Microcap Stocks Guide: Why & How You Should Invest in 2024

If you can invest into a microcap stock that eventually grows into a midcap stock, it can make a real difference to your net worth. Imagine buying a microcap stock at a market capitalization of 700 Cr that eventually trades at a market capitalization of 45,000 Cr, delivering a 60 bagger within 10 years. One single investment at a good allocation of more than 5% of your net worth can take you to the next level of wealth creation

As they say, diversification is needed to preserve wealth. But wealth creation rarely happens through diversification, it happens either through concentration or an outlier investment; sometimes through a combination of both.

Investing in microcap stocks made us successful in the first place; though we started our foray into asset management through a multi cap strategy in the larger interest of investors. Over the past few months, there have been multiple requests from our subscribers to get back to our roots in the form of structured microcap research. This series of research publications on microcap stocks should give us a ready pool of ideas to dip into, when the next attractive opportunity for microcap investing presents itself.

What is a microcap?

If you can invest into a microcap stock that eventually grows into a midcap stock, it can make a real difference to your net worth. Imagine buying a microcap stock at a market capitalization of 700 Cr that eventually trades at a market capitalization of 45,000 Cr, delivering a 60 bagger within 10 years. One single investment at a good allocation of more than 5% of your net worth can take you to the next level of wealth creation

As they say, diversification is needed to preserve wealth. But wealth creation rarely happens through diversification, it happens either through concentration or an outlier investment; sometimes through a combination of both.

Investing in microcap stocks made us successful in the first place; though we started our foray into asset management through a multi cap strategy in the larger interest of investors. Over the past few months, there have been multiple requests from our subscribers to get back to our roots in the form of structured microcap research. This series of research publications on microcap stocks should give us a ready pool of ideas to dip into, when the next attractive opportunity for microcap investing presents itself.

Tara Chand Infralogistic Solutions Ltd

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Garware Hi-Tech Films

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Windlas Biotech Ltd

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Why should you consider investing in microcap stocks?

You should consider investing in microcap stocks because a set of well-chosen microcap stocks can make a real difference to your net worth while keeping yourself reasonably diversified. We made the bulk of our initial money by focusing on microcap stocks in the 2011-13 period when most microcap stocks were trading a Price to Earnings Multiple of 10.

Microcap stocks will test your patience in a negative cycle but will be worth the effort once a good cycle takes off. All good things take time, same with microcap investing.

How to invest in microcap stocks?

To invest in microcap stocks, it is extremely important that you have a well-defined process. Here are the criteria we evaluate as part of our process

  • Addressable market size & potential growth rate
  • Competitive landscape and base rate of success in the specific sector
  • Promoter and management quality & integrity
  • Risk of technology obsolescence for the business
  • Does the current economic cycle offer tailwinds for the sector and the business?
  • Can you trust the numbers of the business?

Chasing buzzwords like “pricing power” and “secular growth” rarely leads to investing success in microcap stocks. Our most successful investment till date has never had pricing power and will most likely never have pricing power; for the longest time the market valued the business like a commodity play. To be successful at microcap investing, one needs to have the same qualities as needed by large cap investing but at 5x the strength –

  • Analytical skills
  • Fortitude to sit through market volatility
  • An optimist mindset without getting too swayed by millionaire dreams
  • Independent, data backed thinking & a tendency to be truth seeking

Microcap stocks are full of investing landmines. Most microcap stocks are microcaps for good reasons, if this type of investing were reliable and predictable, most investors would focus here and leave other segments alone. Who would want to settle for 12% p.a. return over 5 years if one could make 30% p.a. following a predictable pattern?

There is often a temptation to “templatize” microcap investing but do remember one thing; microcap investing is a selection process. As compared to large cap investing which we see as an elimination game. Pure arithmetic dictates this – you have just 100 large cap stocks and more than 3,000 microcap stocks to evaluate.

The most successful microcap investors that we know of do a lot of qualitative and primary work. For some of us, this may not be feasible since we do not have the resources or the time to travel the length and breadth of the country doing plant visits and meeting management teams. We have not done one single management meeting till date, yet have found success in microcap stocks.

One can have a good investment process and a broad set of rules to follow, but one cannot reduce everything to a process in microcap stocks. Outlier results in investing demand differentiated thinking and execution; both from promoters and investors.

What are the best microcap stocks in India?

One way of looking for the best microcap stocks in India is to screen for businesses that display the characteristics that have historically enabled microcap stocks to scale into midcap stocks. 

Our chosen query to arrive at a list of potentially good microcap stocks in India –

  • 5 year sales growth > 12%
  • 5 year profit growth > 15%
  • 3 year ROCE > 15%
  • D/E < 1
  • Dividend payout ratio > 0
  • Promoter pledging = 0
  • Market capitalization between 100 Cr and 3000 Cr
  • Current market price within 10% of all time high

Do pay attention to the filters that can weed out a few pitfalls that are common in microcap stocks. This is not an exhaustive list, there are many more potentially good microcap stocks that are in our tracker whose names do not show up in such screeners. There is no substitute for experience and hard work in the market.

At the same time, microcap investing is not so easy that one can write a screener query and figure out which are the best microcap stocks. Five years ago, the best microcap stocks were all from the consumer sector, today most of them are from the core sectors like Infrastructure, capital goods, power, and renewable energy. The market is forward looking and can trade stock prices higher much before the financials get better for microcap stocks.

To give a broad answer – the best microcap stocks are those that are delivering good numbers in the sectors that are currently in favour. This is how you can benefit from both earnings’ expansion and multiple expansion; this combination acts like a booster dose for your portfolio so long as the positive cycle is intact.

One can either do structural investing or cyclical investing in microcap stocks. The former calls for the ability to do deep work and build the conviction needed to hold a stock for 10 years through multiple periods of volatility. The latter calls for you to be agile enough to move into the right sectors and take profits before the eventual lull occurs.

We sat through two periods of 50%+ correction in APL Apollo to be deserving of the 60x return we can talk about today. If you do not have this kind of conviction and fortitude (after having done the fundamental work to build conviction), please focus on the tactical category and move into the structural category after seeing some initial success over a cycle.

Which microcap stocks have huge growth potential?

Here are the microcap stocks we have researched so far

  1. Garware Hi Tech films
    Garware Hi-Tech Films (GHFL) is an established Indian manufacturer with decades of experience in the polyester film industry. A strategic pivot initiated in FY15 led Garware Hi-Tech Films to focus on value-added specialty films and expand its reach in export markets. This transformation and a lucrative 2020 diversification into the automotive protective films sector have resulted in appreciable growth. Garware Hi-Tech Films offers a unique investment proposition in the specialty film sector at reasonable valuation.
  1. Windlas Biotech
    Windlas Biotech Ltd is a homegrown Generic Formulations Contract Development and Manufacturing Organisation (CDMO) player. Across the value chain, it provides a comprehensive range of CDMO products ranging from product development, licensing, and commercial manufacturing of generic products, including complex generics. We find Windlas Biotech Ltd interesting because it operates in the domestic pharmaceutical formulations industry, which has steady growth prospects. The business appears well placed to deliver attractive revenue growth over FY25 and FY26, with profit and cash flow likely to grow much faster than revenue.
  1. Tarachand Infralogistics
    Tara Chand Infralogistic Solutions Ltd operates in three main areas: a) construction equipment rental; b) cargo handling and logistic services, including warehousing and transportation, mainly for steel; and c) steel processing. TCISL provides its fleet of equipment for use in various sectors. Tarachand Infra Logistics Solutions Ltd provides a unique opportunity to play the capital formation boom in India’s infrastructure sector due to its strong position in Indian infrastructure and steel logistics sectors. With a proven track record, experienced management, and a robust balance sheet, Tarachand Infra Logistics Solutions Ltd is well-positioned to benefit from the ongoing government-led capex cycle. 

We believe that each one of them offers interesting possibilities from here, based on how the specific sector evolves and how the management team executes over the next few years. We hope that some of these businesses will execute their business plans well enough to make it to our core, medium term portfolio of stocks under the advisory service.

While there cannot be any guarantee of good performance by these microcap stocks or even of inclusion in our portfolio for that matter, some of these will become part of our tracking universe. Especially those stocks that are operating in sectors that have visible tailwinds right now. These reports are primarily focused on understanding the business quality, growth potential and risks involved; we are refraining from giving price targets for these stocks right now.

How to find good microcap stocks to invest?

Our investment process based on fundamental factors is articulated here

We use the same process to find good microcap stocks, after making a few necessary tweaks

  • Be where the microcap focused investors are, mingle with them and learn from them. We built a good network of like minded investors at valuepickr, this is usually our go to source for qualitative analysis on emerging stories
  • Build your own stock screens based on parameters like revenue growth, balance sheet quality, earnings expansion, price-volume data that indicates the possibility of interesting changes in the business, shareholding pattern changes that indicates institutional and HNI interest
  • Of the names that emerge from the screening exercise, prioritise the businesses that are operating in sectors that are viewed favourably by the market in this cycle
  • Value chain analysis of the businesses that make the cut – who are their customers, competitors, suppliers where interesting ideas can be found
  • Fundamental deep dive into the business through a combination of financial statement analysis (10 year historical), competitive landscape, industry structure and profit pools, regulatory framework, corporate governance using sources like screener, company annual reports, investor call transcripts and quarterly presentations
  • Promoter and management team analysis
    • What skills enabled the promoter to start the business in the first place?
    • What other business interests do the promoters have?
    • At what point does the promoter want to bring in professionals to run the business?
    • Is the next generation qualified and interested enough to run the show in some years?
    • Has the business invested into bringing more transparency for minority shareholders?
    • Has the business scaled up investments into accounting and reporting infrastructure as the scale of the business increased over time?

Corporate governance checks, evaluating the willingness of the promoter to treat minority shareholders with the respect they deserve and the quality of the reporting processes calls for some amount of real-world experience; for this reason, the best outcomes from microcap investing accrue to those who have sound judgement and not just good analytical skills.

What is the performance of microcap stocks?

Our own experience of investing in microcap stocks when the valuation was in our favour

We exited in tranches with the final tranche at a price of ~9,000.

We continue to hold this stock even today

We exited this stock with ~9x gains within 3 years

Many other instances where microcap investing worked well for us. And some where it did not work as expected. One of the big decisions needed in microcap investing is when to take quick profits; and when to stay with a stock for a long period of time.

Caution – When microcap stock investing works well, the outcome is usually something to cherish. When you get it wrong, you usually lose > 50% of your invested capital

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What are the advantages of investing in microcap stocks?

When investing in microcap stocks goes well (if you do this well), the advantages are evident

  • Multibagger return within a short span of time (< 3 years usually)
  • A healthy allocation to this segment can boost your overall equity portfolio return by 3-4% p.a.
  • Bragging rights of having discovered the next big story much before other investors
  • Financial freedom, if you can invest well across cycles. You get to decide how to live your life and how to spend your time, without compromising on worldly success
  • You become a much better investor across other segments too (mid cap, unlisted etc)
  • The ability to participate in growth pockets, no matter where they occur
  • Develop a very good understanding of emerging business models, very few have this skill

What are the drawbacks of investing in microcap stocks?

There are many pitfalls one needs to watch out for in microcap stocks –

  • Microcap investing is deeply cyclical; there will be some periods where prices go down even after business delivers good results and vice versa. If you get caught in a bad cycle, it will be frustrating for many years before you start seeing good returns
  • Very few microcaps become mid-caps, leave alone becoming large caps. Most microcaps are destined to stay microcaps due to a variety of factors. The base rate of success is not high
  • Some microcap businesses do well but the stock price never gets its due to the behaviour of promoters towards minority shareholders. There are countless examples of a business performing below potential due to promoter actions in the capital market
  • You are the mercy of demand and supply, which you cannot control. Due to the low amount of free float and low market capitalization, a few large counters can impact the prices of microcap stocks within a short period of time. A 10 Cr sell order in a stock of market cap of 200 Cr can send the stock price into lower circuit, exactly on the day you were planning to exit the stock
  • Understanding the scalability and durability of the business well enough calls for a lot of deep thinking and fundamental research. If you do not do this, you will mistake an average business for a good one and pay a high price. Any business can have a few good years, delivering performance over 10 years is never easy
  • Regulatory oversight is only increasing with time. You never know when the regulator steps in to move a microcap into a different equity segment, thereby reducing liquidity overnight
  • You can lose all your capital invested into a microcap stock if things do bad very quickly. Pick up the average demat account and you will see some microcap stocks that do not even trade today. They were the “next big story” a few years ago
  • Doing channel checks on microcap stocks needs dedicated effort and resources, retail investors usually have neither of these
  • Lack of information & research coverage on microcap stocks, unlike large caps and well discovered stocks where analysts churn out research reports every quarter

Despite the many advantages on offer, investors need to tread with caution in microcap stocks for these reasons.

What is the difference between Microcap, small cap, midcap and large cap?

The difference between microcap, small cap, midcap & large cap categories is based on market capitalization as per the regulatory framework.

The difference in market capitalization is accorded to a business by the equity market is largely based on the following factors –

  • Current scale of operations
  • Estimate of future growth rate of revenue, profits & cash flows
  • The quality, predictability and durability of the future growth
  • Assessment of business quality and management quality
  • Assessment of terminal value for the business
  • Current market sentiment

As per the industry classification, the top 100 stocks by market capitalization are classified as large cap stocks. These businesses are usually characterised by professional managers, healthy corporate governance, wide coverage across sell side research, adequate free float, and wide institutional ownership. The bulk of the mutual fund AUM (more than 50%) usually gets invested into these top 100 stocks; hence price discovery is very refined with minimal information & analytical asymmetry. For this reason, it is very difficult for retail investors to deliver higher than market return by investing in a large cap heavy strategy. Active investing in large caps would need a very good understanding of behavioural factors in investing and the ability to stay patient for years together. At Congruence Advisers we do have exposure to large cap stocks but with a predominantly value investing bias. We need to see attractive prices for us to consider investing in large cap stocks.

The next 150 stocks by market capitalization are classified as midcap stocks. This category is not as homogenous as large caps since some midcaps manage to hold onto the flavour of a promoter owned and promoter run organisation. Institutional ownership, sell side coverage tend to taper down as one goes lower down the market capitalization curve. In a historical sense, midcaps have delivered healthier returns than the large cap category but there is some amount of cyclicality involved here too. There have been periods where midcap stocks have underperformed the return delivered by the frontline large cap stocks.

Stocks outside of the top 250 stocks by market capitalization are classified as small cap stocks. Microcap stocks form a subset of small caps going by this approach.

The key mental model to understand here is that the market capitalization of a business reflects both the current business situation and the prospects. We have some businesses that are very large in scale right now but with muted future growth expectations compared to the GDP growth rate of the country. In such cases, the market capitalization accorded to the business is driven more by the current revenue, profits, and cash flows of the business rather than the prospects. Separating both components and having a well-rounded view on the prospects is the essence of prudent investing.

In microcap stocks where the current scale of business is likely to be very small, a bigger part of the valuation is driven by an assessment of future earnings. By design, assessments are subject to probability while the current business scale is a fact. For this reason, higher volatility in stock prices is to be expected if one is dabbling exclusively in the microcap segment. For the same amount of turbulence, a smaller aircraft will be more affected compared to a large aircraft.

“Please fasten your seatbelts” should be a mandatory caution for investors who choose to focus exclusively on small caps and microcaps.

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