4 financial ratios to look out for when investing in small & mid-cap stocks

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Most investors tend to gravitate towards investing in the stocks of large, popular companies that are well-covered by analysts.

However, there are also many good small & mid-cap stocks which are not as well-covered by analysts and hence overlooked by investors.

That said, just because small & mid-cap stocks are less popular doesn't mean they cannot outperform more prominent companies.

The Fama and French Three-Factor Model (developed by Nobel laureates Eugene Fama and Kenneth French) also cites small stock capitalisation as a factor for higher expected returns for a stock.

Two classic examples are

  • AEM Holdings which jumped 244 per cent from $0.825 in Jan 2019 to $2.02 by Dec 2019 and
  • Penguin International Limited which skyrocketed 242 per cent from $0.305 in Jan 2019 to $0.74 by Dec 2019

However, before diving headfirst to invest in small & mid-cap stocks, there are some important financial ratios that you should know and assess.

#1 REVENUE & NET PROFIT

Looking at the revenue and net profit of a company is a good first step to evaluating a stock.

A stock that is enjoying steady or even exponential revenue growth year-on-year would imply that the company is at least able to grow its top-line (i.e. its sales).

If revenue isn't growing, this could mean that the company is in a sector where growth is hard to come by, or that it is not able to leverage available opportunities.

At the same time, just looking at revenue alone may not paint a full picture. You need to also pay attention to its net profits. If a company's cost is continuously increasing at a faster rate than its revenue growth, it's growth may not be sustainable.

#2 GROSS & NET MARGIN

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With all things equal, investing in a company that enjoys a higher profit margin is always better. A high margin means being able to maximise the most out of every dollar of revenue earned. It also means that the company has more leeway to play with the revenue it earns to continue expanding.

Equally important to consider is a company's gross and net margin compared to its sector's peers. If a company has a lower gross and net margin compared to its peers, it could signal that it's less efficient and not able to generate profits as efficiently as others.

Here's a simple way to think of it. At a 1 per cent net margin, a company needs to produce $100 of sales to generate $1 worth of profit. It also means that any increase in its cost, without at least a proportionate increase in revenue, would significantly erode its profit levels.

One good example is BreadTalk Group Limited. Its profit margins have been on razor-thin margins of 2 - 4 per cent and recently spiralled into losses due to escalating costs.

Hence, keeping a healthy gross and net profit margin is essential, and investors should look to invest in stocks that reflect this.

#3 OWNERSHIP 

Another crucial factor is to look at companies where the founder(s) continue to retain the majority of shares.

Small & mid-cap companies usually get a head start with the founder(s) as the management team. As such, when the founder(s) own a majority of the shares, it shows that they are committed to the company and have the vested interest to see the company grow and succeed.

On the other hand, a management team without any vested interest may simply run the business for the sake of a chunky salary or not have the shareholders' interests in mind.

Hence, the continuous presence of a strong, talented founding team continues to be vital for a company's success.

#4 FINANCIAL POSITION 

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Understanding a company's financial position is also another top priority for investors.

For example, an investor should pose this question:

"how much does the company hold in net cash position to provide support for new investments or buffer against headwinds?"

If a company holds a large amount of debt while its cash holdings is low, this may signal that the company's growth and profits are generated through the debt borrowings.

On its own, this may not be a bad thing since it means that the company can grow its business using debt. However, this can be a risk area if interest rates increase, or if a company encounters a challenging business landscape, which makes it unable to meet its short-term cash requirements.

This article was first published in Dollars and Sense. All content is displayed for general information purposes only and does not constitute professional financial advice.