Small Cap: Multibagger or Fraud?

Small cap: multibagger or fraud? 1

So what to look for in small cap or just about to become a mid cap company? Is it a “multibagger” or a fraud?

These are some of the points that I look for and in no way this list is exhaustive

1. Cash Flow statement

Yes P&L is great for ratios and all but in a small company with not a lot of data, it is important to see if it is actually making any money.
Look for cash flow from operations and check if it is growing or not.

2. Short term liabilities

If there is one thing that I have to have to look in a company it will be it short term liquidity.

“You need to survive short term to be alive to see the long term”

Is the company raising short term debt to manage its working capital? If yes, how much of short term debt was for just meeting the WC needs? Can the cash flow support the short term obligation?

3. Working capital management

Great people at top have one thing in common – they know how to manage the working capital

How is the inventory moving with respect to sales? Is the inventory at the risk of going obsolete? In how many days do they take get the money from their buyers? How quickly do their suppliers need money?

4. Off balance sheet items

Check for unfunded pension liabilities (it should not be a problem in a young company but do check it)
For sure check for contingent liability – This is the MOST IMPORTANT item to check in any company financials.

5. Cost of goods sold

Is the gross margin constant or in a tight range or is it moving wildly?
If it is all over the place, exit immediately as the company is either a fraud or the management has no idea on how to purchase raw materials

6. Employee cost and management pays

Great management comes at a great cost. Check for management salaries. If the company has good disclosures they may even mention the parameters that decides the bonus of the management (large cap companies will give this). If stock price is one of the parameters, smile.

If employee cost is not increasing while sales is jumping, there is a high chances there is a fraud. The company is bumping up its margins to push the stock price. Take your call.

7. Depreciation

How is the company depreciating it’s fixed assets? Too aggressive? Or slow?
It is a subjective call so talk to a CA friend on this.

8. Are there Convertible bonds on the balance sheet?

If there are, your small stake in the company may get diluted further. So think about it

9. Dividends

Most small caps and mid caps don’t give dividend as the company usually get invested back into the business. But if they do, love them. They want to reward long term investors and for sure they are making cash flow.

10. Do you see their product?

If the company sells its product directly to consumers, do check with your local kiranawala or the shelves in big bazaar.
In fact, stroll around the shelve in a big bazaar and check who all picks it. And when they pick, have a look at their cart – what all are they buying other than this product? It will give an idea of the consumer profile.
But please don’t stalk the consumer.

Finally, if you have done all the above, you can do the Discounted cash flow and ratio analysis.