With the benchmark indices ruling at lifetime highs, it is the microcaps space that remains the last bastion of relatively cheap valuations, analysts at ICICI Securities said.
However, some experts advise investors to tread with caution in the segment and not allocate more than 5 percent of their portfolio to microcaps.
“The current microcap universe valuation in terms of trailing earnings yield, excluding loss pools, is 6 percent (trailing P/E of 16x-17x) as compared to 4 percent for large caps (trailing P/E of 24x), thereby offering reasonably cheap valuations in terms of risk spread in a bull market environment,” ICICI Securities said in a strategy note.
The domestic brokerage has assumed the microcap universe to be consisting of stocks with market cap rank from 501 to 1,000.
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“Going by the past trends, ‘risk tolerance’ towards microcaps has room for expansion if the current bull market continues,” it added.
Earlier instances of bull markets in broader equities have seen microcap earnings yield spread over large-caps drop to near-zero versus current spread of 150-200 bps. “Assuming that the current bull market continues, driven by a broad-based investment cycle, the probability of a repeat of past behaviour cannot be ruled out,” it said.
Mid and small caps, on the other hand, have marginal earnings yield spread over large caps, although they too have not reached extreme bull market valuations in which they trade at a premium to large caps.
In the microcap universe there are around 80 stocks with Return on Equity (RoE) greater than 10 percent and earnings yield more than the 10-year government bond yield, which allows screening within a wider universe of stocks available at cheap valuations with minimum quality standards.
The Nifty Microcap 250 index has a significantly high weight of 68 percent in the broader industrial sector and discretionary consumption, which could benefit from the current demand environment in the economy.
This is because the post-pandemic GDP recovery is being driven by growth in gross fixed capital formation (GFCF) and higher-end discretionary consumption.
ICICI Securities’ top microcap picks include Wonderla Holidays, Somany Ceramics, Greenpanel, Sansera Engineering, ISGEC, Fusion Micro Finance, Repco Home Finance, Nazara Tech, Tatva Chintan, Astra Microwave, Kewal Kiran and Gokaldas Exports.
Headwinds at play
This is not to say investors should blindly rush into the microcap segment.
“Apart from being largely cyclical in nature, microcaps have another major risk in terms of liquidity with bulk of the stocks having an average daily turnover of below Rs 100 million. Hence, in an economic downturn-driven bear market, the ‘beta’ factor works against microcaps along with liquidity risk, thereby, resulting in sharp corrections,” ICICI Securities said.
Some analysts, in fact, urge extreme caution.
Market veteran and Chairman of Elyments Platforms Ajay Bagga said retail investors should avoid the microcap segment.
"Microcaps are subject to huge manipulation and there is little institutional coverage or ownership. Not more than 5 percent of one's portfolio can be dedicated to this cap segment. Stick with quality and reap the benefits of India's growth and momentum," he told Moneycontrol.
Analysts have also highlighted weakness in underlying economic parameters.
Kotak Institutional Equities, in a report, said it does not see any specific reason for the recent surge in smaller companies. It said India's weak consumption demand should have had a negative impact on smaller firms, as recent commentaries from companies show no signs of improvement.
Contrary to popular belief, microcaps are not companies with less than Rs 1,000-crore of market capitalisation. In fact, the smallest microcap in the Nifty Microcap 250 – GRM Overseas - has a market cap of Rs 1,009 crore.
According to NSE indices, microcaps are companies that rank below 500 and up to 750 in market capitalisation ranking. The top 100 are largecaps, 101 to 250 are midcaps and 251 to 500 are smallcaps.
The microcap space is seeing increased traction in recent times.
Motilal Oswal AMC recently launched India’s first Nifty Microcap 250 open-ended index fund.
Also Read: A rare microcap index fund debuts, but not for the faint hearted
Globally, there are funds tracking the Wilshire 5000 and an even broader MSCI World Microcap Index with close to 6,500 constituents.
The Nifty Microcap 250 index has given over 47.45 percent returns in the last one year, compared to the Nifty50’s 20 percent.
Another point to note is that of the 250 stocks that comprise the microcap space, only 31 companies have more than five analysts covering it, 112 companies have less than that and 107 companies have no coverage at all. The average number of analysts covering a microcap is just two.
This paucity of investment research in the microcap universe can be a big stumbling block for investors looking to venture in the segment.
Some experts also advocate a more broad-based approach while evaluating smaller companies. “We think the better way to look at companies is to categorise them as per profit size, rather than market cap. There are about 600 companies in India which make net profit in excess of Rs 100 crore and that is our universe,” says Rajesh Kothari, Founder and CIO at AlfAccurate Advisors.
Disclaimer: The views and investment tips expressed by experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.
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