Tips to make big gains from small companies

Looking for multibaggers? Try PE-backed listed firms.

Anil Raut's hunt for multibagger stocks led him to small market capitalisation companies that are backed by private equity. His logic: If a PE fund has invested money in the company, there is a growth story to it.

But, there is only a 50 per cent chance of his success. Out of the 23 listed small-cap stocks that received over Rs 1 crore (Rs 10 billion) PE money in 2009-2010, the share prices of 14 have risen from the time the stake was purchased. (See box)

Seven of these have risen by more than 50 per cent, with P I Industries gaining as much as 228 per cent in the last 10 months. The stock closed at Rs 503 on August 30. When Standard Chartered Private Equity invested on November 5, 2009, the price was Rs 153. The entry of a PE firm is good news for investors for many reasons:

Growth prospects
PE firms expect close to 25 plus per cent returns. Consequently, they put in hard work towards this end. A recent study by research firm Venture Intelligence showed that over a period of eight years (2000-2008), PE-funded firms recorded high growth in sales and profitability and spent more on research & development as compared with their non-funded peers in the industry.

Cheap valuations
PE firms prefer purchasing cheap and exiting at a high price. So, in many cases, the valuation of the company will be quite attractive.

Due diligence
Arun Natrajan, managing director, Venture Intelligence, says, "The longer the presence of a fund, the better the company's credibility in meeting the benchmark valuations".

"Putting money in a PE-backed company should give some comfort to the investor because it is 'smart money' being invested by a sophisticated long-term investor who expects higher returns", says Raja Kumar, CEO of mid-cap PE fund Ascent Capital. So, buying stocks where the PE fund has taken preferential allotment may be a good idea as the fund will remain invested for at least a year. But the strategy can be risky as well.

High risk, high return
Anand Rathi, chairman, Anand Rathi Securities, cautions investors from buying PE-backed stocks. "PE funds see their investments as high on risk and return, and mirroring their investment strategies may not work for the retail investor", says Rathi.

Preferred treatment
Unlike an individual investor, a PE firm is more likely to get into deals that assure a certain return, even if the company fails to deliver. Agrees Vikram Utamsingh, markets and PE advisory, KPMG India, "A PE transaction could be structured differently (equity only/equity plus warrants), and so its returns will be impacted by these structures." A retail investor's ability to make money, on the other hand, will be driven by market forces.

For investors keen on PE-backed listed companies, here are some do's and don'ts:

Long term: Most PE funds have a minimum three-year outlook for the company they invest in. Investors should try to remain for just as long.
 

Spread your bets: Typically, PE funds bet on ten companies and hope to recover money from only two-three. Investors cannot afford to do this. So, their exposure should be small and diverse.

Allocating funds: Even those with a high risk appetite should invest only 10-20 per cent of their portfolio. The bulk of their money should be put in tried and tested instruments.

New strategy: Another way of entering a PE-driven firm is by investing with a number of other individuals. "Many PE funds have started accepting smaller ticket investments from high net worth investors to be invested in smaller ventures. This allows them to get exposure to a portfolio of smaller companies, which diversifies the risk", says Sanjay Sinha, CEO, L&T Mutual Fund. But only look at firms that have managed multiple funds of this nature.