The S&P BSE Sensex and the S&P BSE 500 are hovering close to their all-time peaks. On the contrary, the S&P BSE Mid Cap index is 19% away from its historic high. The BSE Small Cap index is down 34% to its milestone (see table: Lopsided rally).

Investing in small- and mid-cap stocks is risky. Unknown promoters, absence of succession planning and differences among the promoters are some of the downsides. A small balance sheet with limited capacity to absorb economic and business shocks is an issue.

Small and mid caps tend to operate in specialized industries. Hence, there is limited scope for growth in revenues and profit, thereby capping gain. A tiny issued share capital limits liquidity and exposes vulnerability to wild swings in prices. Sparse or absence of institutional presence means lack of pressure for transparency and disclosures, thereby hampering the discounting. Share offering at regular intervals is a red flag.

Despite these shortcomings, small- and mid-cap stocks remain promising opportunities to achieve superlative returns. A firm with market capitalization of Rs 5000 crore is in a better position to generate healthy returns compared with a company with a market value of Rs 50000 crore. Small- and mid-cap companies can be fast-movers in their businesses.

Several small and mid caps have created wealth through corporate actions such as dividends including interim and special dividends and bonus shares. They have maintained discipline in their dividend payout policies. Buyback has been deployed to reward the shareholders. Many have little or no debt. Indeed, a few have significant cash and cash equivalent in comparison with their net worth and market capitalization.

Niche players are seen commanding high market share due to superior technology derived through tie-ups. Some are part of multinational groups. There is institutional presence in the form of mutual funds, insurance companies, global institutional investors and private equity investors among others in a substantial number in these small and mid caps. Quite a few proactively interact with the shareholders through conference calls and analyst meets, taking care to an extent of the patchy information in public domain.

One of the simplest ways to take exposure to small and mid caps is through mutual funds. However, there are certain pitfalls (see box: Mutual discord). The downside of direct exposure can be mitigated through diversification or by creating a basket of a number of small and mid caps. Stringent selection criteria have to be put in place, considering the fact that the stock market is at its zenith and valuation can soar further because of slowdown in earnings growth.

Capital Market shortlisted small and mid caps with no or limited equity dilution in the last five years. Only those with market capitalization lower than Rs 5000 crore were picked, covering the entire gamut of small caps and the lower strata of mid caps. Based on the 80:15:5 rule, the small caps have market value less than Rs 2600 crore, mid caps between Rs 2600 crore and Rs 17000 crore and large caps above Rs 17000 crore.

Only companies making profit and paying dividends were selected. Stocks with mutual fund presence and generating decent returns over the last five years were preferred. The list contained small and mid caps whose revenues and profit recorded a compounded annual growth rate (CAGR) of 10% and above over the last seven years. Basically, these companies delivered in the past. Last, debt-to-equity ratio of less than 0.75 times were considered.

Vesuvius India is one of the most popular small-cap stocks with institutional investors. Mutual funds held 20.73% equity stake end December 2018. Vesuvius Plc, the ultimate parent listed on the London Stock Exchange, is a global leader in metal-flow engineering, principally serving the steel and foundry industries. The manufacturer and trader of refractory commands 12% market share. Investors need to monitor the steel cycle closely to envisage the demand scenario. At the moment, customers have shelved their expansion projects and are looking forward to the outcome of the insolvency proceedings against steel manufacturers. Around 15% of the revenues came from exports in the calendar year (CY) 2018.

The zero-debt company had cash and cash equivalent of Rs 113.8 crore and bank balance including fixed deposits of Rs 305.5 crore end December 2018. The cash on balance sheet is significant considering its market value of Rs 2390.3 crore. The overall receivables from the three customers against whom bankers had initiated insolvency proceedings under the Insolvency and Bankruptcy Code, 2016, were considerably reduced in CY 2018.

Nocil, the Arvind Mafatlal group company, is the largest rubber chemicals manufacturer in the India. There are long-term relationships with customers in over 40 countries. On offer are a wide range of rubber chemical products in a variety of forms, with tyre being the main user industry. The domestic tyre industry has already committed around Rs 1500-1800 crore for expansion plans. Around 71% of the revenues came from exports and 29% from exports in the nine months ended December 2018.

Phase I of the capital expenditure program, involving Rs 170 crore, was completed in December 2018. Phase II, entitling an investment of Rs 255 crore, is underway. Capacity expansion of the rubber chemicals plants at Navi Mumbai and Dahej in Gujarat is being undertaken. The enhanced capacity is set to go commercial by October 2019. The expansion, expected to give an asset turnover of 2 times, will be mainly funded through internal accruals. Further expansion is contemplated.

Increase in cost of manufacturing in China is resulting in a level-playing field for Indian players. Significant revenues (55% of the total) from value-added products and anti-dumping duty protection are positives.

Persistent Systems in January 2018 approved buyback of equity shares through the open market for an aggregate amount of Rs 225 crore, or approximately 10% of net worth, at a maximum price not exceeding Rs 750 per share. An interim dividend of Rs 8 per share of face value of Rs 10 has been announced for the fiscal year ended March 2018 (FY 2018). The debt-free software solutions provider had cash and cash equivalent of Rs 1533.7 crore end December 2018 compared with Rs 1137.8 crore a year ago.

Nearly 83.5% of the revenues came from North America, followed by Europe (7.5%), India (6.3%) and rest of the world (2.7%). In terms of segmental revenue mix, services contributed 43.8%, followed by alliances (27.6%), digital (21.3%) and acceleraite (7.3%) in FY 2018. Of late, business has slowed down. Revenues grew 11.1% to Rs 2534.1 crore and profit 7.1% to Rs 267.2 crore in the nine months ended December 2018, mainly due to the depreciation in the rupee against the US dollar.

eClerx Services issued bonus shares in the ratio of 1:3 in December 2015 and 1:2 in July 2010. Critical business operations services are provided to over 30 global Fortune 500 clients including many of the world's leading financial services firms, online retailers and distributors, interactive media, luxury brands and entertainment, high tech and industrial manufacturing, travel and leisure, and software vendors, through operational support, data management and analytics solutions,

Incorporated in CY 2000, the country's first publicly listed knowledge processor (KPO) has over 8,500 employees across global delivery centers and offices at Verona in Italy and Phuket in Thailand and in Mumbai and Pune in Maharashtra and Chandigarh, a Union Territory, besides global client relationship locations in New York, London, Philadelphia, Silicon Valley, Austin, Dublin, Milan, Munich, Hamburg and Singapore.

The debt-free industry-focused specialist managing and improving complex data-driven processes had cash and cash equivalent of Rs 721.9 crore end December 2018 equaled to Rs 190 per share compared with Rs 172 crore end September 2018. The board mid March 2019 approved buyback of equity shares at a maximum price of Rs 1600 on face value Rs 10 for an aggregate amount of Rs 262 crore.

Mayur Uniquoters in February 2019 declared a third interim dividend of Rs 2 per share, or 40% on face value Rs 5, for FY 2019. The artificial leather maker acquired 68.18% equity stake for US$4.5 lakh in US-based Futura Textiles, a retailer and wholesaler of upholstery of polyvinyl chloride or artificial synthetic leather. Futura's turnover was US$ 25.6 lakh in CY 2017.

One of the largest producers of synthetic leather, with an installed capacity of 3.05 million linear meters per month, serves the twin segments of footwear and automotive. Major clients include Maruti Suzuki India, Mahindra & Mahindra, Tata Motors, Isuzu, Honda Motors, LML Vespa, Suzuki, Sonalika Tractor, General Motors, Lear, Bharat Seat, Swaraj Auto, Polor Auto, Renault, Volkswagoan, Hero MotoCorp, Bajaj Auto, Piaggio, Bata, Action, Lancer, Relaxo, Paragon and the VKC Group.

Production of polyurethane (PU) leather is expected to start by June 2020. Construction work has commenced at the Morena plant in Madhya Pradesh. The unit will address the estimated 20 million meters per month domestic demand for PU leather, currently catered by imports.

Bajaj Consumer Care, formally Bajaj Corp, markets hair oil brands such as Bajaj Almond Drops Hair oil, Bajaj Brahmi Amla Hair Oil, Bajaj Amla Hair oil and Bajaj Jasmine Hair oil. Flagship Bajaj Almond Drops Hair oil is the largest selling in the domestic premium hair oil segment and commands one of the highest per unit price. Oral-care products are marketed under the brands Bajaj Red and Kala Dant Manjan. Nomarks is a popular skin-care brand.

As many as 3.98 million retail outlets are serviced by 8,869 distributors. The rural market's contribution of 40% to the revenues is likely to increase going forward. The debt-free company had cash and investment mainly bank fixed deposits, corporate bonds and liquid mutual funds of Rs 266 crore end March 2019. A dividend of Rs 14 per share, or 1,400% on face value of Re1, was paid for FY 2019 compared with Rs 12, or 1,200%, for the previous year.

Established in 1989, Bodal Chemicals operates in the three sub-segments of dye intermediates (capacity of 33,000 tonnes and 25 products), dyestuffs (35,000 tonnes and 175 products) and sulphur and bulk chemicals ( 2.26 lakh tonnes and 12 products). There is 3% share in the global dyestuff market and 6% in the worldwide intermediates market. The share is 13% in the domestic dyestuff market and 25% in the domestic dye intermediates market. The manufacturing and distribution infrastructure includes nine units in Gujarat, one in Uttar Pradesh and four depots. Around 45% of the basic chemicals and dye intermediates are captive-consumed.

About 45% of the revenues came from exports to over 150 customers spread across 45 countries in the nine months ended December 2018. The top domestic customers are Atul, Aarti Industries, Clariant, Jay, McFills and Chemistar. International clients comprise Basf, DyStar, Farben, Hustsman, Stahl, OhYoung and Archroma. The growth strategies of the almost zero-debt company consist of increasing capacities of the core business, expanding reach into different geographies, diversifying into specialty chemicals and focusing on gradual margin expansion. The dyestuff capacity was expanded 12,000 tonnes in FY 2018 and 6,000 tonnes recently.

Mold-Tek Packaging, established in 1986, makes injection molded containers for packing lubes, greases, chemicals, paints, bulk drugs, inks and synthetic adhesives. The aggregate injection molding capacity of the seven processing plants is around 20,000 tonnes. There are three stock points spread across India.

Construction of a plant at Mysuru in Karnataka to manufacture of rigid plastic containers was completed recently. Commercial production started in the fourth quarter of FY 2019. Around 90% of the construction at the Vizag plant is complete. Commercial production is expected to start shortly.

As a part of cost-reduction initiative and better utilization of overall capacities, two injection molding machines have been transferred from the Rak (Ras Al Khaimah) unit in United Arab Emirates to the Hyderabad unit in India. Manpower has been reduced to appropriate levels. A major order is expected from a large customer from the paint industry in the UAE. Based on the receipt, decision will be taken on the continuation of the Rak unit.

Pharmaceutical producer Suven Life Sciences undertakes drug discovery and development and contract research and manufacturing services (Crams). There is presence across the entire Crams value chain including intermediates and bulk drugs. Relationships have been established with over 30 global pharmaceutical companies. The board approved the demerger of the Crams division, Suven Pharmaceuticals, subject to permission from regulatory authorities.

Work in progress include SUVN-502 (phase 2a trial in the US), SUVN-G3031 (ready-to-start phase 2 in the US), SUVN-D4010 (completed phase 1 in the US), SUVN-911 (ongoing phase 1 in the US) and SUVN-I6107 (ready-to-start phase 1 in the US). Research and development (R&D) activities are focused on the central nervous system disorders. The R&D expenditure is funded through internal accruals. R&D expenditure of Rs 42.4 crore was incurred in the nine months ended December 2018 compared with Rs 41.5 crore in the previous period.

The mid cap is making profit and paying dividend since listing in CY 1995. The debt-free company had cash balance of Rs 300 crore end September 2018. An interim dividend of Rs1.50 per share, or 150% on face value of Re 1, was declared in February 2019.

Incorporated in 2006, Future Supply Chain Solutions is a third-party logistics service operator covering the entire gamut of supply chain services across the logistics value chain including warehousing, transportation and distribution system, temperature controlled logistics and last mile delivery logistics. The pan-India distribution network offers integrated warehouse management systems and a hub-and-spoke transportation model to provide better services and reduce cost. Customers are in industries such as fashion and apparels, food and beverages, consumer electronics and high tech, automotive and engineering, home and furniture, healthcare, general merchandise and e-commerce sectors.

Operations are run through 91 distribution centers covering approximately 7.31 million square feet (msf) of warehouse space. The warehouse space increased 0.91 msf in the quarter and 2.7 msf in the nine months ended December 2018. The hub-and-spoke distribution model comprises 14 hubs and 136 branches covering 11,746 pin codes across 29 states and five Union Territories. Also, there are 835 containerized vehicles and 116 owned refrigerated trucks.

India Food Grid, a network of multiple integrated food distribution centers launched across the country in January 2019, is expected to redefine the food and FMCG supply chain in India. The grid will provide pan-India distribution reach, right from manufacturing hubs till the point of consumption.

Cera Sanitaryware has a share of 15% in the sanitary-ware market and offers brands such as Isvea and Senator in the premium and luxury segment. Products are offered across all the categories and price points. The Jeet brand was launched in the medium segment recently. The estimated share is 3% in the faucet market. The flagship brand is Cera. A 51% equity stake was acquired in Anjani Tiles in CY 2018 to fortify market position.

Clients are across industries such as real estate, hotel and construction and include public sector undertakings and the railways. Nearly 45% of the revenues came from west, 40% from south and the remaining 15% from north and east in FY 2018. The marketing network consists of 2,841 dealers and 11,306 retailers. Six wind power plants, with a capacity of 13.8 MW and taking care of around 90% of its power demand, are owned and operated in Gujarat. The zero-debt company, with cash and cash equivalents of Rs 150 crore mid-March 2019, has been paying dividends regularly over the last 30 years.

The MP Birla group company Vindhya Telelinks manufactures and sell telecommunication cables, other types of wires and cables, glass rovings, connectorized cable products and solar poly-vinyl cables and is also in the engineering- procurement-and-construction (EPC) business. The growth drivers for optical fibre cables include government initiatives such as Digital India and BharatNet (plan to connect 3.5 lakh gram panchayats with broadband connections). Also, the rollout of 4G technology will be crucial.

The EPC division executes surveys, designs, supplies, installs, commissions, operates and maintains complete system integration services of telecom and power cable networks, rural electrification networks and smart city networks including electric sub-station installations, sewerage system and irrigation systems. Mutual funds held a 8.59% equity stake in the small cap end March 2019. The debt-to-equity ratio remained moderate at 0.21 times, with debt of Rs 470.6 crore end FY 2018.

Conclusion

Screening small- and mid-cap stocks for investment is a challenging task. Lack of adequate information is a hindrance. The financials of the two categories of companies reveals nil or marginal debt on the balance sheets. In fact, some of the select companies have significant cash and liquid investments at their disposal. Many can be seen having a high market share in the niche segments in which they operate. Long vintage is another positive. Mutual fund presence provides comfort.

Some of thee companies have opted for business expansion, thereby providing revenue visibility. Small companies with strong balance sheet, proven business model, good quality promoters and sufficient business opportunity can emerge as multi-baggers in the long term.