As yet another electrifying season of IPL draws to a close displaying some of the finest cricketing talents from around the world. What stands out this season is the sheer number of uncapped players who caught the attention of fans and selectors alike- From a player smashing 5 sixes in an over to a player taking 5 wickets in an eliminator. These players are redefining the cricketing rule book and are embracing unorthodox ways of playing, they are not worried to play audacious shots against experienced bowlers.
Drawing parallels
Microcap stocks, similar to uncapped players, possess the advantage of being unburdened by complex hierarchies due to their small size. This inherent agility and adaptability enable them to swiftly respond to evolving market conditions. Moreover, these small-scale enterprises are often characterized by a substantial promoter stake, demonstrating a strong commitment to success and a willingness to take higher risks. In a business landscape dominated by large companies, these companies focus on specialized market or product that sets them apart from the larger and more diverse competitors.
However, size of these companies can be a double-edged sword. On one hand, their small size grants them agility and flexibility in decision-making. However, it also brings challenges such as limited resources, reduced bargaining power, and vulnerability to market fluctuations.
What micro caps have to offer?
Micro cap stocks, by nature, often operate in niche markets and industries that are not well-represented in larger counterparts. These companies tend to focus on specialized areas or emerging sectors that have the potential for significant growth. As a result, investing in micro caps can provide exposure to unique opportunities that may not be available through larger, more established companies.
Additionally, micro caps often exhibit different risk-return characteristics compared to larger-cap stocks. While they can be more volatile and have higher risk profile, they also have the potential for greater growth and higher returns. By including micro caps in a portfolio, investors have the opportunity to enhance their overall portfolio performance through potential capital appreciation from these smaller, high-growth companies.
Undiscovered investment opportunities
Microcaps despite their growth potential, often find themselves overlooked by analysts. The focus of analysts tends to be on larger and more liquid companies, leaving fewer resources available for researching microcap stocks. For instance, data from Factset reveals that, on average, only 2 analysts cover microcap stocks, whereas 27 analysts cover large-cap stocks. A further deep dive shows that a whopping 40% of the microcap companies receive no coverage.
Investing in small, under-researched stocks takes more time and effort, thus making the microcaps an often-underinvested segment by institutions particularly. As of May 2023, only 4% or 69,000cr of mutual fund industry’s AUM is invested in stocks beyond the top 500 companies. This highlights a blind spot among institutional investors, leaving significant room to finding undervalued or overlooked stocks that have not yet been fully recognized by the broader market.
Small firm effect at play?
In addition to being undiscovered, studies have indicated that small companies tend to provide higher risk adjusted return than their larger counterparts, a phenomenon often referred to as ‘small firm effect’. Simply put, it is a tendency of small stocks to outperform their larger counterparts due to factors like illiquidity premium, risk premium etc. Plausibly this effect may have aided in the Nifty Micro 250 Index outperforming its larger counterpart, the Nifty 50 index. As of May 2023, on a 3yr CAGR basis the Nifty Microcap 250 index posted ~58% return as against 26% by Nifty 50 index. Even on a 3-year rolling return basis the Nifty Microcap 250 index has outperformed the Nifty 50 by 2%, for a period of 18 years, albeit at a much higher risk. Microcaps tend to have relatively higher volatility and historically exhibited relatively higher and longer drawdowns.
To sum up, the microcaps present a unique investment opportunity that have a very high growth potential yet they are often overlooked as an investment opportunity. Investing in microcaps may help enhance portfolio returns. Long term investors who have the stomach to see drawdown and patience to wait for them to recover should consider this segment.
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