How to woo quality investors How to woo quality investors

The jury is still out on how much money will actually flow to mid and small caps on the back of the recent regulations of SEBI (Securities and Exchange Board of India) with respect to allocation of flows in multicap funds, we have attempted to identify factors that would encourage funds to invest in mid and small caps in spite of the inherent limitations of liquidity (given the float) and vulnerability due to the absence of scale. 

Vision and purpose combined with a clear execution strategy -Where does a company want to be in three to five years and what are the steps it is embarking on to get there? COVID-19 and other extraneous factors that increase volatility in business conditions are now the new normal.  The key is that this is a journey and ‘progress over perfection’ is the monitorable. A clearly articulated  ‘Purpose’ for all stakeholders including employees needs to be in place.

Shareholding and float - A promoter holding between 50 per cent and 55 per cent is a good start to ensure adequate float and this also allows the promoter to increase stake in volatile markets.  If there is a pledge, a good sense of the rationale and the time frame to free up the pledge is key.  Investors dislike pledge, potential margin money calls and most importantly unrelated investments using equity as a collateral. 

A clear articulation of the industry and a company’s positioning with a focus on how the company is dealing with a VUCA (Volatility, uncertainty, complexity and ambiguity)  world in terms of benefitting from shifts like unorganised to organised, premiumisation, impact of digital transformation in the operating model, geo- political factors and fundamental principles around reducing concentration on product, customer, etc. is imperative. The ability to be innovative and nimble is a key differentiator in building a moat. 

Mid and small caps need to demonstrate how within a defined period, there is an opportunity to scale up and be dominant in their niche.  Investors look to both growth and return ratios as they evaluate companies. Diversification to ‘market friendly’ segments (currently pharma and specialty chemicals) without having a well-defined rationale is a huge negative. Return ratios like ROCE (Return on Capital Employed), ROA (Return on Assets) and the ability to earn free cash [EBIDTA (Earnings Before Interest, Depreciation, Taxes and Amortisation) to FCF (Free Cash Flow)] are key monitorable.  A well -articulated dividend distribution and borrowing policy is a big plus.  

This is one of the key factors that drive quality investors. It would include having an independent board, a good management discussion and analysis, and a clear articulation of how the company is dealing with both opportunities and threats.  Revenue and profit guidance has to be given only with an adequate sense of factors that could change this as the street dislikes surprises.  Material events -a sharp change in tariffs, loss of a key customer, exit of key managerial personnel, etc. – should be communicated before the street knows it. Keeping corporate structures as simplistic as possible is best.   

This is a huge ‘smell test’ for investors in terms of family members of the promoters engaged in the supply chain or employed in the company.  If there are such transactions, the key will be to highlight the rationale, but the best would be to minimise such dependence.  This applies to both reported related party transactions and more importantly those that do not fit the definition for reporting.

While investors understand the founders are key for the success of most small and mid-caps, broad basing of management especially in support functions like finance, IT and R&D are a huge positive.  Pedigree and their ability to talk to the street on investor calls is key too.  Frequent changes in these roles which may be coincidental is a huge red flag, in terms of the ability to attract and retain diverse talent so key for building scale.  

This is a double -edged sword.  We often see over eager managements. Investor communication is an art and the balance between what is relevant and shows both commitment and transparency is a key objective of communication strategy. Annual reports, investor calls and analyst meets are great platforms to communicate effectively. 

Very often family settlements can throw up shocks for investors.  This could be in the form of loss of managerial talent, to promoter shares finding its way with speculative investors.  This needs to be dealt with proactively to ensure investor confidence is not shaken.  A proper transition plan to manage loss of talent or ensuring that shares are placed with quality investors will go a long way to ensure investor confidence. 

Whilst we have highlighted some proactive steps to be taken by mid and small cap companies, we believe that induction of quality investors will go a long way in enabling the next ‘mid cap’ to ‘large cap’ journey, something that all stakeholders would aspire for!!

(A version of this article appeared in The Economic Times on 12 October 2020 )