Small is Profitable Too!

Small is Profitable Too!

The biggest risk in equity market investment is not the volatility but the risk of wiping out of the capital. The risk of capital erosion is at its maximum when one invests in micro-cap companies – at least that is what the perception is. Shreya Chaware explores the pros and cons of micro-cap investing while also highlighting the performance of the tiny treasures

When it comes to equity investing, one of the important questions every investor struggles to find an answer to is how much of the total portfolio money should be allocated to small-caps, mid-caps and large-caps. Often the fine judgement of portfolio allocation across market capitalisation comes with experience and after studying the risk profile of individual investors. For a conservative investor it is recommended that 90 per cent of the portfolio money allocated for equity investments should be parked in large-caps and the remaining 10 per cent in mid-caps and small-caps. If the investor’s risk profile suggests higher risk-taking ability, in that case the allocation can be 50 per cent in small-caps and mid-caps with 50 per cent in large-caps.

For a moderate risk-taker, the recommended portfolio allocation is 70 per cent in large-caps and 30 per cent in small-caps and mid-caps. If one sticks to the above suggested portfolio allocation derived after a thorough risk profiling is done, chances are the experience in the equity market will be good as the portfolio will be aligned to the risk-taking ability of the individual investors. Now, how does one accommodate micro-cap stocks in a portfolio that shows promise? What are micro-cap stocks and should micro-cap stocks be included in the portfolio at all? It is perceived that micro-cap stocks are highly risky and not for conservative investors. However, for those investors with higher risk-taking ability, micro-cap investing is not untouchable.

Micro-Cap Portfolio Building
To start with, it is important to distinguish between penny stocks and micro-cap stocks. Penny stocks are the ones whose share price is less than Rs10 per share or even Rs20 for that matter and the market capitalisation is lower than the small-caps. Micro-cap stocks have low market capitalisation and usually trade with low volumes on the bourses. Typically, micro-cap companies can be the ones below market capitalisation of Rs1,000 crore. Then we also have something called nano-caps. Stocks with market capitalisation less than Rs100 crore or even Rs200 crore are at times called nano-caps. Historically speaking, we find that micro-cap companies are almost always risky for investment.

This is not only due to inherent volatility but also on account of the probability of wiping out of the complete capital. Says Chetan Tupe, a micro-cap investor: “I think micro-cap investing is grossly underrated by individual investors. There is lot of money to be made in micro-cap stocks and the so called nano-cap stocks. If one applies the basics of investing principles to micro-cap stocks, a market-beating portfolio can be constructed. Yes, there is a risk of not only capital erosion but a complete wiping out of the capital if a wrong micro-cap is selected, but overall if a portfolio is constructed of hand-picked micro-cap stocks after through research, beating market returns is a cake-walk.”

“As to whether it is a high-risk, high-reward game, definitely yes. It is an extremely rewarding experience in my view. In my portfolio I have invested at least 20 per cent of my capital in micro-cap companies. The trick in micro-cap investing is portfolio diversification and understanding the businesses of small-sized companies. Reading the balance-sheet and profit and loss statements will not suffice while investing in micro-cap companies. One will have to try to listen to the promoter. Understand the strategic initiatives that the promoter is focusing on and try to translate those initiatives into earnings. These days the promoters of micro-cap companies who have a solid story to tell do interact with investors online. I ensure to attend those investors’ meets on a regular basis,” he adds.

Attending such meets or interactions provides a realistic perspective on a company’s business growth which in turn helps build conviction. A basic hygiene check is just a mandatory task to scan opportunities in the micro-cap investing world. A thorough fundamental analysis is a must; however, there are practical problems while analysing data for micro-cap companies because of the lack of comprehensive data on company financials. One has to dig deeper for the data and rely on annual reports for basic information about the micro-cap companies. The following table highlights the outperformance of the micro-cap companies: icro-cap investing is a great form of investing for those who have the ability to operate in the market in a disciplined manner and believe in portfolio diversification. The diversification needs to be wider when one invests in micro-cap companies.

Micro-cap investing is a great form of investing for those who have the ability to operate in the market in a disciplined manner and believe in portfolio diversification. The diversification needs to be wider when one invests in micro-cap companies.

Conclusionx
Micro-cap investing is a great form of investing for those who have the ability to operate in the market in a disciplined manner and believe in portfolio diversification. The diversification needs to be wider when one invests in micro-cap companies. By wider diversification what we mean is that instead of holding 12-14 stocks in the portfolio one needs to have at least 20-25 stocks with small allocation spread over 5-10 micro-cap stock bets. Overall exposure can be restricted to 20-25 per cent of the portfolio at the maximum if one is a high-risk investor. By doing so the portfolio can generate an alpha and it will be possible to beat the market in the long run. No advance research technique is required to beat the markets. One just needs to keep it simple and focus on the growth levers.

It is more important to understand whether the promoter is capable of delivering on the growth promises. A good amount of time should be spent on understanding the capabilities of the promoter. This additional effort of estimating promoter strength while analysing the prospects of any micro-cap company can be the deciding factor. When one invests in any large-cap company the promoter track record is more or less proven. The promoter is assumed to be a wealth-creator. Such comfort is not available to investors of micro-cap stocks and hence there is an additional unknown when investing in micro-caps. The lack of track record of the promoter is clearly the additional risk one takes while investing in micro-cap companies along with the unavailability of information about the company.

However, micro-cap companies these days are seen reaching out to investors via various mediums and every attempt should be made by the investors to study the details of the business model before investing in a micro-cap company. Micro-cap companies are also notorious for being operated by certain punters who tend to be manipulative. Because micro-cap companies are low-liquid stocks, even a small above average buying quantity can move the prices substantially. Hence, micro-cap companies are prone to manipulation by the so-called market operators. However, a carefully selected micro-cap company with a durable business model will eventually see buyers’ participation on the rise which leads to volume increase in the counter in the long run, thus leading to profitable exit opportunities.

 

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