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The Indian general elections have come to an end. The NDA government is now
back in power for a third term.

This means there will be policy continuity in the government. And that’s good news
for the stock market. A renewed mandate could lead to increased inflows of funds
into the market. This could result in potentially rising valuations of stocks across the
board.

We at Equitymaster, believe the bull market is not under threat and long-term
investors have nothing to worry about. It's just that, in the short-term, there could be
some volatility. Once the elections are done, history tells us, the markets continue
their merry way.

However, specific segments of the market could respond in different ways. For
example, if the market moves higher after the elections, it’s very likely that smallcaps
will outperform largecaps.

Why?

The earnings for over 900 stocks in the smallcap index suggest a growth
(compounded annually) of over 20% in the last four years. Considering it uses pre-
pandemic year as base, this is impressive.

Furthermore, the growth in earnings has come along with stronger balance sheets
and capex activity. All these are good grounds for a rerating in smallcaps.

So how should you approach investing in smallcaps now?

In this guide, we will examine the current state of smallcaps in the market, how you
should approach investing in these stocks, and the key points to keep in mind.

First, here are some words of wisdom when it comes to investing in smallcaps…

Consider investing in a group of stocks which are fundamentally strong, especially

smallcaps and are also indifferent to the 2024 elections.

In other words, stocks that are dependent more on the broader long term India
growth story and are not directly related in any major way to the popular themes of
the Modi government.

Best Smallcap Stocks 2024 – Modi 3.0 Edition | 2

Also, it does not make sense to wait on the sidelines now that the elections are
done. Invest in quality smallcaps that offer enough comfort on sustainable growth
over next five years. If you can pick quality smallcaps at attractive prices, you are
likely to do well in the long term.

With that, let’s dive into the current state of smallcaps in the Indian stock market.

Investing in Smallcaps Today in the Indian Stocks Market

Before the recent volatility, small-cap stocks were on fire.

I drew up a list of stocks with highest gains in 2023. And I wasn’t surprised to see
almost all of them from the smallcap space.

I have mixed feelings about the rise of smallcaps and the smallcap index. Before I
get into the reasons, here’s some recent history for you…

2022 was a big speed breaker for BAAP (buy at any price) and growth at any price
investors.

With the cheap money out of the picture, a lot of high-flying stocks saw the wind
beneath their sails disappear.

However, the sentiments shifted again. From a big sell off in March in 2023, the
smallcaps rebounded, and how.

The smallcap index scaled new all-time highs in 2023 and early 2024. For individual
smallcaps, the upswing was even higher.

You see, that's the nature of smallcaps. When sentiments are adverse, they take
the hardest knock. When markets are upbeat, the slightest nudge could send them
soaring.

It's good to see smallcaps rallying. But this comes with a sense of caution. Markets are
cyclical. And there may be a point when the valuations run ahead of fundamentals.

How close or far are we to that point?

While this point would be different for each business depending on their
fundamentals and stock price, let me share my view on smallcaps in general.

3 | Best Smallcap Stocks 2024 – Modi 3.0 Edition

Let's first check the general market sentiments. At present, the benchmark indices,
Sensex/Nifty, are near their lifetime highs. The Sensex is trading at a PE of almost
25. This is a level saner than the peak of 36 in 2021.

But it’s still at a premium to its long-term median of 20.2 and not too far from some
of its previous peaks.

Here's a very simple conservative or base case prediction for Sensex in the next
five years. The Sensex earnings have grown at a CAGR of around 13% over the last
two decades.

If I expect the earnings to grow at the same rate over the next five years, and use
the median PE multiple of 20.2 times, the Sensex could be close to 96,000.

Let's assume 100,000 for the sake of simplicity and let's see what the implied upside
could be for smallcaps from current levels.

The PE ratio for smallcaps does not make sense. That's because over 4,000 stocks
fall in this category, lot of which are loss making and junk stocks where earnings are
a non-meaningful concept.

Due to the lack of a sensible PE ratio, here’s another metric: The Smallcap to
Sensex ratio.

The smallcap to Sensex ratio at present stands at 0.6 times. This compares to the
previous peaks ranging from 0.58 to 0.76 in the last two decades.
Also, the ratio currently is at a sharp premium to the long-term median of 0.44 times.

Best Smallcap Stocks 2024 – Modi 3.0 Edition | 4

 Smallcap to Sensex Ratio
0.8

0.7

Long term median at 0.44

0.6

0.5

0.4

0.3

0.2
Dec-03 Dec-07 Dec-11 Dec-15 Dec-19 Dec-23
equitymaster Data Source: ACE Equity

Here’s what this means…

You would not find enough low hanging fruits in smallcap space. If you are not
diligent and selective while picking these stocks, your investment journey could be
doomed.

It’s a good time to use this momentum for profit booking in some cases where the
growth prospects and balance sheet do not support valuations.
That said, in my view, it does not make sense to wait on the sidelines but invest in
quality smallcaps that offer enough comfort on sustainable growth over next five
years.

Here's are few pointers I would recommend picking high potential smallcaps in this
market.
• Are cash flows in alignment with earnings?
Earnings can be manipulated easily, such as with depreciation policies,
capitalising recurring expenses, changing inventory policies and so on. But
it’s difficult to manipulate cash.

A consistent divergence deserves some digging in and due diligence.

5 | Best Smallcap Stocks 2024 – Modi 3.0 Edition

 Cash flow from operation could be a bit out of tune with earnings. Depending
on the nature of the industry, a peer comparison and comparison with past
trends could be very insightful.

I prefer small-cap stocks with positive cash flow from operations.

• Is the balance sheet suited for business to grow in a self-sustainable
manner?
For non-banking stocks, I prefer businesses where debt to equity ratio is less
than one.

That's because I like businesses that can grow in a self-sustainable manner. If

a business needs too much external capital for growth, the quality of growth
is questionable.

Such businesses end up being at the mercy of interest rates and macro
environments and may not be the best investment bets for the long term.

• Does the business generate healthy return ratios?

A lot of investors pay attention to profits. Few are conscious of returns
generated by a business.

A business X requiring an investment of Rs 100 and earns a revenue and

profit of Rs 50 and Rs 20, is likely to have a better economics compared to
business Y that needs an investment of Rs 500 generating revenue of Rs 50
and profit of Rs 25.

For X, the profit margin is 40% and return on capital employed (RoCE) is
20%. For Y, the profit margin is 50% and ROCE is 5%.

So, it’s not the profit margin but ROCE that is a better indication of the returns
you will make on an investment.

• How do the valuations fare compare to long-term median valuations?

Don’t rush into an investment without due diligence for the price you are
paying.

You could compare with the long-term historical PE of the same stock, as
well as with the peers in the same industry.

Best Smallcap Stocks 2024 – Modi 3.0 Edition | 6

 Sometimes, depending on how high a price you have paid, good businesses
can turn out to be bad investments.
Finally, and most important…
• Is the management good enough to consider a partnership with?
Long-term investors should approach investing like a business partnership.

Unlike well established businesses that run on an almost auto pilot mode,
for smallcaps, the management quality is the biggest make or break factor.
Sometimes, amid a rally, people ignore this factor.

Smallcaps should be treated not just as price tickers but businesses the
prospects of which would be made or marred by the competence, integrity,
and focus of the management.

Avoid stocks with very high promoter pledging. This weakens the
management control of the business. It could lead to selling pressure amid
bearish sentiments in the stock.

So, that was about the process of selecting smallcaps in current times. If you
can pick quality smallcaps at attractive prices, you are highly likely to do well
in the long term.

So, what are attractive prices? Who decides what is an attractive level for
the stocks.

Return on equity, debt to equity, consistency in profit margins, cash conversion

cycle, pledging, growth, management quality, cash flows compared with
earnings, and historical and current valuations are some tools analysts like
me use.

We all work with imperfect and limited information publicly available to us

about the businesses. We try to connect the dots and the variables that
could influence the business to get some sense of what the future could
look like.

Sometimes, unexpected variables like Covid and lockdowns get thrown into
the equation, upending all the analysis.

7 | Best Smallcap Stocks 2024 – Modi 3.0 Edition

 This does not guarantee a 100% success. But if the process and allocation
are right, there is a high chance of beating benchmark index returns by a
wide margin.

There are well experienced fundamental analysts who use the same method
and yet could end up arriving at different target prices.

Sometimes, the same stock may be given a Buy view by one analyst, and Sell
by another analyst, based on their deductions from the same information.

So, who can you count on?

I hope your answer is not hot stock tips, finfluencers, stock price tickers,
economists, and market experts with their ‘sure’ views on mainstream
financial channels.

That’s a relentless amount of information, intended to serve them, not you,

dear reader.

However, if you have done the basic analysis, I'm going to talk about someone
who help you polish your stock picking process. You get to know not just the
names of the stocks to buy. But also, a sense of the price at which it would
make sense to buy.

That person is none other than the management or promoter of the business.

Unlike tips that you come across on social media that could be just a front
running exercise, a promoter is invested in the business for the long haul.

Keeping track of what they do with the stocks of the companies they own
could give you interesting insights.

Peter Lynch has said,

‘Insiders might sell their shares for any number of reasons, but they buy
them for only one: They think the price will rise.’

Of all the stakeholders, promoters know the most about their businesses
and future potential.

If they are willing to part with their personal money to buy stocks from
open market, there is good possibility that they believe that the stock is
undervalued and could gain in the future.

Best Smallcap Stocks 2024 – Modi 3.0 Edition | 8

 The good news is this: You can access this data for free on BSE website.
Watch my video here to know how to get this data.

At a time when markets are rallying, insider buying activity could be a good
starting step in the stock picking process.

Just picking a good smallcap at an attractive price is not enough. The smallcap
space is fraught with volatility. You need to have the right temperament to let
your investments compound.
Here are a few principles…
• Focus on long term
If an event is not going to be relevant in 3 to 5 years from now, it's not
important now.

Inflation, oil prices, exchange rates, rate hikes, quarterly earnings, expected
growth and margins in the coming quarter and countless other parameters
that analysts endlessly harp on fall in this bucket.
• Focus on what you can control
Covid was a big lesson for managements, analysts, and stock market experts.
The one factor they hadn't factored in their plans and excel projections
turned out to be the biggest variable, throwing all their predictions out of
the window.
Companies with reasonably conservative management and strong balance
sheets emerged stronger out of it, while the weaker players were shunted
out.

Investors with prudent asset allocations managed to ride the crisis without
losing their sleep and resorting to panic selling.
Forget the unknowns. In investing, one cannot even control the known
risks. One can only acknowledge them and operate within the circle of
competence and with margin of safety in valuations to minimise the damage
in case of adverse developments.

9 | Best Smallcap Stocks 2024 – Modi 3.0 Edition

 • Have reasonable expectations from your investments.
Peter Lynch has said,

In this business, if you're good, you're right six times out of ten. You're
never going to be right nine times out of ten.

Well, like it or not, that's the metric of success for one of the greatest investors.
In smallcap investing, do not play expecting you will never lose. What matters
is to win big, to make up for the losses you make and to be less wrong than
the broader markets.

This humble approach not only makes you prudent in your selection, but
also lets you to stay the course to win the war, even if you lose the battle.

It also helps you develop a capacity to suffer when the stock you own
witnesses a sharp correction. Over the entire course of a market cycle, this
is a very likely phenomenon.

Again, your capacity to suffer and conviction to hold will be a function of how
well diversified your portfolio is and how well you understand what you have
invested in.

I hope what you have read so far helps you develop the right skill set and mindset
to make the most of the potential in the smallcap space.

Despite the market indices trading at a premium to long term median, I believe that
most of the future multibaggers will emerge from the smallcap space.

So, if you wish to join me on the journey of finding smallcap multibaggers, I

recommend you start here…

Regards,

Richa Agarwal
Editor and Research Analyst, Hidden Treasure

Best Smallcap Stocks 2024 – Modi 3.0 Edition | 10

Coverpage image source: MicroStockHub / www.istockphoto.com

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