How to profit with small-cap stocks

A few weeks ago, we discussed in this column titled “Do small-cap stocks perform better than big caps?” that while small caps rise faster than larger stocks, they do not provide above-average returns on a consistent basis due to higher risks.

Small-cap stocks are known to be riskier because they tend to be “junky” compared to large stocks.

In fact, about 45 percent of small stocks in the Philippine Stock Exchange (PSE) with a market capitalization of P5 billion and below are unprofitable. This is not to mention that many small caps are also typically less liquid, financially unstable and have poor growth prospects.

Because of these, investing in small stocks requires a higher rate of return to compensate for the additional risks.

But, be that as it may, not all stocks share the same risk profile. There are small caps that are less risky because they are better managed and more promising.

Small-cap stocks, particularly those with significant growth potential, can be a lucrative investment opportunity because their share price can appreciate many times over in the long term.

For example, Megaworld Corp. was once a small-cap stock with market capitalization of P2.7 billion when it was first listed in the PSE in 1994.

Over the years, with consistent growth in earnings, Megaworld has increased its market value by almost 49 times to P131 billion today, which translates to an annual return of 16 percent a year.

In a market where every small-cap stock has a story to tell, it is not easy to identify which one has the greatest potential to grow in the future when there is no solid financial track record to begin with.

So, in order to lessen the risks, it is safer to select small-cap stocks with measurable quality features such as profitability, capital efficiency and growth.

There are two quality metrics that we can use to screen small-cap stocks: the earnings yield, which measures a company’s profitability relative to its enterprise value, and the return on capital, which calculates how well a company utilizes its fixed assets and working capital to generate profits.

If we applied these two metrics to screen small-cap stocks in 2010, RFM Corp. would emerge as one of the most promising stocks, which had earnings yield of 20 percent and return on capital of 17 percent. In 10 years, with steady growth in earnings, RFM’s market capitalization would increase by almost 10 times from P1.9 billion in 2010 to P18 billion today, delivering a 25- percent annual return.

If we run the same process to the current batch of small stocks with market capitalization of P5 billion and below, we will find several stocks with double-digit metrics such as Ionics, Phil Racing Club, Mabuhay Vinyl, Crown Asia and Cityland.

However, the problem with most of these stocks, based on historical performance, is the liquidity of shares and lack of compelling growth outlook, which lowers the overall quality premium.

Perhaps, newly listed Fruitas Holdings Inc., which has market capitalization of P2.9 billion, can be a better option because it has higher quality features in terms of profitability and growth.

Fruitas generates an operating profit that is four times larger than its net capital and an earnings yield of 9.5 percent. Given the scalability of its business, with fresh capital from the initial public offering, the company can easily expand its earnings in the near term.

Remember that higher earnings lead to a higher share price. A small company’s ability to grow its earnings consistently over and above its cost of capital is what makes its stock grow into mid and large-cap stock over time.

While it is true that small-cap stocks may be risky, in general, focusing on long-term growth potential of the company by assessing the quality of its financial strength and profitability can help limit those risks. INQ