Selecting Micro-Cap Companies With Potential

Micro-cap investing and growth investing are considered synonymous in the sense that investors turn to micro-cap stocks because small companies are considered to have greater growth potential. Yogesh Supekar explains the various ways to identify micro-caps with potential 

Whenever the broader markets rally, we find that the investor portfolio tends to outperform the key benchmark index. It is because investors usually include several stocks from the broader markets in the portfolio. The lure for micro-cap investing and Small-Cap investing is the high growth potential in the stock prices when compared to the Large-Caps and Mid-Caps. However, we know by now that the market is not all about returns but it is almost always about the risk and return trade-off. 

Says Hitesh Oberoi, who has been focusing on micro-cap and SME stocks for beating markets: “When you invest in equity markets, you must be prepared mentally for a temporary drawdown. It is always painful to see your portfolio in the red. It is more of a psychological risk than anything. It is true that micro-cap stocks usually tend to have higher drawdowns than their mid-cap and large-cap peers but the upside potential in quality stocks more than compensates for the risks if the stock you have invested in is a quality stock. If a micro-cap stock lacks fundamentals and has a poor business model, the chances of it bouncing back are very rare even when the markets recover.” 

“In my portfolio, where maximum concentration is on micro-cap stocks, I pick stocks with outstanding results and those which are trading near their 52-weeks’ high. I usually invest not more than 5 per cent of my portfolio capital in any single bet. However, whenever I find a promoter with vision and with the capability to execute a pre-defined business strategy, I tend to bet heavy. A micro-cap company with consistent outstanding results, scalable business model, operating in the right growth sector, attractive valuations and led by a visionary promoter is a sure-shot recipe for multibagger returns given the market conditions are conducive and not corrective,” he adds. 

“In my own experience of micro-cap investing, I think reading promoters correctly is extremely important. Proper and thorough due diligence becomes even more important while investing in micro-cap companies. A detailed diligence process also helps us build conviction in a particular stock. Going forward, looking at the India growth story there is no doubt in my mind that several micro-cap companies will grow at a much faster rate,” he further states. 

Micro-Cap Stocks with Potential

The checklist for identifying a micro-cap stock with potential can be lengthy. However, one must not skip on the following aspects while identifying micro-cap companies: 

◼ Promoter Vision and Capabilities — It is not easy to always easy to quantify the upside potential of stocks for micro-cap companies as the information availability is inadequate. As such, trusting and judging a promoter’s quality is the most basic and necessary step while investing in micro-cap companies. The advantage with micro-cap companies is that the promoters are relatively accessible when compared to the large-cap and mid-cap companies. Any micro-cap company with a sound and scalable business model, technical competence and with project execution skills can be invested in. Usually investing in micro-cap stocks is a bet on a promoter because the numbers are not there for all of us to see and analyse. There is not much of a track record. Earnings are extremely volatile and it can scare away most of the investors who believe in number crunching. Building conviction in any micro-cap company is actually building conviction on the promoter. 

◼ High ROCE, High ROE — If one finds a micro-cap company in a high-growth sector with high ROE (return on equity) and high ROCE (return on capital employed), such micro-cap stocks should be on the watch-list immediately. Proper due diligence in micro-cap stocks with high ROCE an ROE can improve the odds of finding quality portfolio stocks. Simply put, a high ROCE and high ROE indicate efficiency of the management. 

◼ 52-Weeks’ High — Any share trading at 52 weeks’ high or near its 52-week high indicates positive momentum in the stock price. To start with, investors can filter all the micro-cap stocks that are trading at fresh 52-weeks high or are near the 52 weeks high. This activity will only help identify the trending micro-cap companies.

◼ Financial Trend — It is important that investors do not miss studying the financial trend of the micro-caps. The growth in earnings is what matters the most for the stock prices in the long term. EPS growth in recent quarters and years needs to be observed. After this, based on management projection and guidance, investors can estimate the EPS growth with approximation. Logically, one should bet on those stocks that promise growth on consistent basis. Positive financial trend, while important, should not be the most important criteria for selecting micro-cap companies. The reason is that most micro-cap stocks with potential are busy executing the business plan and grabbing market shares and hence the numbers may look attractive only in the future while the present numbers may look less attractive. Thus, the existing numbers should not be given more importance than required and the trick is to forecast how good or bad the numbers can be in the coming quarters and years. 

◼ New Product Launches and Work Orders — Any new product launch or bagging of a new work order can act as a positive trigger for the micro-cap stocks. As the size of the company is usually small, a huge work order running into multiple crores can trigger a rally in the stock prices. 

Conclusion

Investing in micro-cap companies can be risky for those who fail to adopt a disciplined approach to investing. For those who are disciplined and have a predefined investment process with focus on quality aspects of the company have an excellent opportunity to identify ‘tiny treasures’ that promise to make it big in the future. Any investor who wants to beats the market by focusing on micro-cap stocks needs to build high conviction in the prospects of the company. High conviction will come after analysing the promoter and management of the company, studying the industry prospects, visiting the factory site if it is a manufacturing company, understanding the leadership team’s master game plan to increase the market share, new product launches and profit margin trends for the company.

As the information availability is scarce for micro-cap companies, it can be extremely useful for the investors to meet and or interact with promoters and the key management team if possible. This exercise will help investors understand the management and their capabilities better. Tracking company updates on a regular basis is important while taking exposure in micro-cap companies. Any negative update can lead to selling pressure which can push the stock prices lower by a huge margin, thereby leading to heavy losses in no time. Similarly, any positive update can lead to a sharp jump in the stock prices. Investors need to be quick while making entry and exit decisions because of the wild swings in the stock prices of micro-cap companies.

The rewards can be greater in micro-cap investing if one is able to find a right company in the most trending sector. For example, if there is an existing positive trend for renewable energy, identifying a micro-cap company in the same sector with a promising promoter can be your ticket to experience multi-bagger returns. Accurate sectoral analysis (view) and the ability to identify megatrends in the economy and industry which can possibly lead to explosion in earnings at company levels can prove extremely profitable in the long run for any micro-cap investor.