Strong small-cap stocks trading at attractive valuations

With most of the large-cap stocks touching their peaks in terms of valuations, there has been a growing interest in quality small- and mid-cap stocks over the last few months. Against this backdrop, we looked for small-cap companies trading at attractive valuations as against their growth over the last five years.

While searching for small-cap growth companies, we used the following filters. First, we picked up companies with an average return on equity greater than 20 per cent. Thereafter, selected companies with revenue growing more than 20 per cent in the last three years. Thereafter, in order to ensure reasonable valuation and growth prospects, we selected only those companies with price-earnings growth (PE/five-year earnings growth) of less than one. And the result was a list of 16 companies. Finally, since all these are small-cap stocks, we used cash flow from operations to operating profit metric and narrowed down on companies that had the least variation between the two metrics. We used this metric because of the concern of the quality of earnings. And we identified the following three companies:

KEI Industries
A manufacturer of cables and wires used for industrial and home applications, this company is also involved in undertaking various engineering, procurement and construction projects. The company's products are used across sectors, comprising power, railways, automobiles and oil refineries, making it a leader in the segment.

Like other industry players, the company has focused on expanding its distribution footprint and enhancing brand image over the years. Its dealer network increased from 1,147 in FY17 to 1,450 in FY19, while its branding expenses increased from Rs 7.5 cr to Rs 19 cr during the same period. The company's focus on enhancing its retail revenue, which generates higher margins than its industrial customers, drove a substantial rise in the company's branding expenses. The contribution of sales from retail increased from 27 per cent of the total sale in FY15 to 33 per cent in FY19. However, this has also led to a slight increase in the operating margins over the years.

Of late, the electricals space has garnered more attention, with the government announcing various schemes to increase the availability of electricity across the country. Over the years, KEI has been able to capitalise on several opportunities, which are reflective in its sales and earnings, increasing at an annualised five-year growth rate of 20 and 70 per cent, respectively. During the same period, the company simultaneously decreased its debt/equity ratio by half, which now stands at a healthy 0.8 times. The company currently trades at a PE of 18 times, down from its five-year median of 22 times.

APL Apollo Tubes Ltd
A manufacturer of electric resistance welded (ERW) steel tubes, black pipes, galvanised pipes, pre-galvanised pipes and coils, the company is prone to cyclicality in steel prices. Having distribution in 29 cities with 790 dealers, it has been able to double its market share over the last five years (from around 10 per cent in FY15 to 18 per cent as of now). Since it mainly caters to the infrastructure and construction industry, the company is likely to benefit from the government's ongoing focus on the infrastructure sector.

Going on an expansion spree, the company is all set to acquire Apollo Tricoat Tubes in FY21. With this acquisition, the company will be able to expand its existing product portfolio and get a first-mover advantage in the galvanized product segment. These new products would cater to a niche market of water solution products. Besides, the company's manufacturing capacity will increase from the current 2.1 million tonnes per annum (MTPA) to 2.55 MTPA following the acquisition of Apollo Tricoat Tubes and another plant that it is also planning to acquire. The agreement for the latter's acquisition took place during FY19.

Coming to the financials, while its sales volumes have nearly doubled from 709 MTPA in FY15 to 1339 MTPA, however operating margins have come back to 5.5% in FY19 after increasing from those levels in FY15. The company had to take a loss on inventory levels owing to a fall in steel prices, leading to a fall of 6% in earnings. Even though its debt/equity ratio has slightly decreased over the last five years from 1 in FY15 to 0.9 times currently, its interest costs have seen a substantial rise (70%) owing to an increase in short-term borrowings. Sales and earnings, on the other hand, have increased at a five-year annualised growth rate of around 20 per cent. The company currently trades at a PE of 21 times, higher than its five-year median of 12 times.

Sandur Manganese and Iron Ore
Headquartered in Bellary, Karnataka, Sandur Manganese & Iron Ores Limited (SMIOL) sells manganese, iron ore, ferroalloys, steel products and silico-manganese. It also generates power through a 32-MW thermal power plant located at Vyasanakere, Karnataka, which is used for its ferroalloy operations. Iron ore constitutes 46 per cent of the company's total turnover, followed by ferroalloys (30 per cent) and manganese ore (24 per cent). Although the company was earlier into the exports market, it now only caters to the domestic market and primarily supplies to steel manufacturers in the region, including JSW steel. Hence, this is another small-cap growth company prone to the volatility in steel prices.

When it comes to iron ore, the company produced 1581 kilotonnes (kt) in FY19. Although the production is up from 712 kt in FY15, there is no production growth from the previous year. The company believes that the risk associated with iron ore is the reduction in prices as a result of higher imports, which could strain profitability. However, its manganese ore production was up to 285 kt in FY19 from 106 kt in FY15. It's Low Grade Manganese Ore is known for its low phosphorus content (below 0.05%) and has the unique reputation of being one of the finest low grade, low phosphorous metallurgical ores and used in blends for manufacture of ferroalloys and steel.

Coming to the financials, the company's sales volumes of iron and manganese ore have increased at an annualised five-year growth rate of 24 and 33 per cent, respectively. However, in value terms, sales have increased at an annualised five-year growth rate of 15 per cent and earnings at 32 per cent. The company is debt-free and has a return on equity of 24 per cent, which is significantly up from around five years ago where the return was eight per cent. For mining companies, price to book is the preferred metric for valuation. This company trades at a price to book of 0.96 times, down from its median of 1.36 times.

Disclosure: The intent of the article is not to recommend any specific stocks. If you wish to invest in any of the above-mentioned securities, please do thorough research.