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.
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.
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.
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 –
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.
Our chosen query to arrive at a list of potentially good microcap stocks in India –
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.
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.
We use the same process to find good microcap stocks, after making a few necessary tweaks
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.
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
Despite the many advantages on offer, investors need to tread with caution in microcap stocks for these reasons.
The difference in market capitalization is accorded to a business by the equity market is largely based on the following factors –
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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