Micro-caps may give alpha returns in bull market

Notwithstanding the risk involved, analysts are upbeat on micro-cap investing as India remains in a firm bull market.

Moreover, these stocks are available at relatively cheaper valuations compared to large, mid and small caps, assuring alpha returns.

With a market-capitalisation (market-cap) of up to Rs 10,000 crore, micro-cap stocks are outside the purview of Nifty 500 stocks, and are ranked from 501 to 750 in the market-cap ladder.

“Once micro-caps start moving in a bull market, they outperform benchmarks by a large margin as investors look at them for alpha (higher than normal) returns.

"While immediate outperformance from micro-caps could be limited due to their sharp year-to-date (YTD) rally, this pocket could be looked at from a long-term perspective given the bull market in India,” said Ambareesh Baliga, an independent market analyst.

Thus far in calendar year 2023, 165, or 66 per cent, of 250 micro-cap stocks have generated positive returns.

Of these, 151 stocks have outperformed the benchmark Nifty50 index, and 148 have outperformed the Nifty500 index, data shows.

By comparison, the Nifty50 index has advanced 3.24 per cent, Nifty500 4 per cent, and Nifty Microcap 250 15.5 per cent during the period.

Individually, Jindal Saw, Titagarh Railsystems, Kayens Technology, Datamatics Global Services, Mrs Bectors Food, Safar Industries, Newgen Software Technologies, Ramkrishna Forgings, and Power Mech Projects have vaulted between 60.4 per cent and 137 per per cent, ACE Equity data suggests.

High risk, high return

Since micro-cap stocks are under-researched and involve a high degree of risk, analysts believe a professionally managed fund may be a better way to put money in these stocks.

“When the Nifty50 moved from 16,000 to 18,000, the micro-cap space didn’t perform much.

"However, when the benchmarks are testing all-time high levels, the incremental money is chasing micro-cap stocks to make a quick buck.

"Given the strong fundamentals of the economy, and likely sustenance of earnings growth, the overall strength in the market will support this pocket too,” said Manish Jain, fund manager - Coffee Can PMS, Ambit Asset Management.

Despite this outperformance, the current micro-cap universe valuation, in terms of trailing earnings yield, is about 6 per cent (trailing price-to-earnings (P/E) of 16x-17x) as compared to 4.3 per cent for large caps (trailing P/E of 24x), said a recent note by ICICI Securities.

This, the note said, highlighted reasonably cheap valuations in terms of risk spread in a bull market environment.

On the other hand, mid and small-cap valuations over large-caps have diminished significantly with their average trailing earnings yield at 4.7 per cent.

“Earlier instances of bull markets in broader equities have seen micro-cap earnings yield spread over large-caps drop to near zero vs current spread of 150-200bp.

"If the current bull market continues, driven by a broad-based investment cycle, the probability of a repeat of past behavior cannot be ruled out,” said Vinod Karki and Niraj Karnani of ICICI Securities.

Against this backdrop, the brokerage picks Wonderla Holidays, Somany Ceramics, Greenpanel, Sansera Engineering, Fusion Micro Finance, Nazar Technologies, Tatva Chintan, Astra Microwave, and Gokaldas Exports as its top picks.

That said, analysts advise investors to be mindful of micro-caps’ cyclical nature and low liquidity.

Bulk of stocks have an average daily turnover of less than Rs 10 crore.

Hence, micro-caps correct far more than other stocks in a bear market.

"Micro-caps are a subset of equities that carry higher trading risk in terms of trading liquidity, business volatility etc. Hence, an investor needs to invest with a longer time horizon than mid or small caps.

"It deserves a place in a seasoned investors' asset allocation as part of a satellite portfolio," said Trideep Bhattacharya, CIO-Equities, Edelweiss MF.