Investing in micro-caps and small-caps successfully

Pradeep Gupta
Co-founder & Vice Chairman Anand Rathi Group

Investing in micro-caps and Small-Caps successfully

Small-caps and micro-caps offer high growth potential, but investors need to look at the company’s fundamentals, promoters’ credentials, sectoral outlook, company’s valuation and its key ratios before investing, says Pradeep Gupta, Co-founder & Vice Chairman, Anand Rathi Group 

With regards to equity market, there are three major factors that drive it – fundamentals, both macro and corporate, liquidity flow towards the equity market and equity valuations. In terms of fundamentals and valuations, India is better placed than most of the major economies. The domestic flow into the equity market is also supportive of a buoyant market. However, the global risks and the consequent foreign portfolio outflow from Indian equity market has been the main reason why Indian equities continue to remain in the volatile zone in the short term.

The US Dow Jones index was up by 14% in October, while the gain in tech-heavy NASDAQ was down 2.1%. NIFTY 50 was up 5.4% for the month, thereby turning positive for YTD CY22. The broader markets ended marginally positive with S&P BSE Midcap and S&P BSE 250 Smallcap being up 2.0% and 1.8%, respectively. The rally was seen across sectors, led by the rate sensitive sectors like Banks, PSUs and Autos. Almost all sectoral indices closed higher than the previous month. FIIs turned net buyers in the last 15 days of the month. Strong domestic inflows continued with domestic institutions buying stocks worth ~USD 1.1 bn in the month of October.

The growth rate of corporate earnings is slowing down substantially. This trend is likely to continue. Having said that, there has been substantial downward revision of earnings growth expectations by the analysts. Due to this, modest upside earnings surprise over the next 12 months cannot be ruled out. At the same time, there has been a significant downward rating of valuation multiples over the last one year. A major reason for this could be sharp increase in discounting rates. It is expected that the policy rates would stabilise in the first half of 2023. With this expectation, there can be modest re-rating of valuation multiples. This can counterbalance the deceleration in earnings growth. Overall, we do not expect significant downside to the equity market even from a 6 to 9 months perspective.

Looking at the current economic scenario, I believe that the current investment outlook should be strategic as opposed to product-driven. 

While investing, especially in the small-cap and the micro-cap space, investors need to look at the fundamentals of the company, liquidity need, credentials of the promoter group of the company and how stable the same is, any adverse news concerning the company, the period for which investors are looking to invest in and the sectors that the companies are operating in. You should also look at the valuation and the key ratios that help determine how healthy a company’s balance sheet is. 

Small-caps offer high growth potential but are also extremely volatile in nature.

Stocks work wonderfully when picked from the bottom of a bear market and this is mostly true for small-cap companies because this segment takes the brunt of the bear hit and when they bounce back, they show higher momentum from a low base.

However, at an investment level, one should assess the investment objective and the risk associated with the investment vehicle and the investors own risk taking abilities. Would you be okay to witness humungous volatile periods? That is the answer which investors must answer before allocating their funds in small-cap and micro-cap stocks. While small-caps and micro-caps should form a part of investor’s portfolio, it should be managed well and should not have overexposure in the same. 

An asset allocation strategy with a well-diversified portfolio is the key to managing risk and ensuring low deviation from the expected outcome. Everyone’s risk taking capabilities differs and there are various ways to measure your risk tolerance. Investors must understand the overall risk associated with the asset allocation strategy.

As a major part of global risk gets priced in equity markets, in the absence of fresh shocks or negative news, the market is likely to go into a consolidation mode and eventually this can lead to a market rally if investors’ risk appetite returns. While India has corrected and faced outflow of foreign portfolio investments along with the global markets, as the situation gets stabilized globally, the attractive fundamentals and valuations would attract capital into India. In view of this, we are not surprised that in the recent past the foreign portfolio investor sentiments seem to be turning positive towards India.

When we are investing for the long term, short term volatility will always prevail but, at the end of the day, the fundamentals matter.