Micro-cap Stocks Rally Drives Mutual Fund’s Interest, But Are They Worth Investing?

September 28, 2023 Mutual Fund

The Micro Cap segment of the equities has caught the fancy of investors and mutual funds amid a strong rally in the broader market.

In the last one year, the Nifty Microcap 250 – TRI index has gained 44.3%. This index comprises the top 250 companies beyond the Nifty 500 index, i.e. micro-cap companies ranking from 501st to 750th based on their average full market capitalisation.

In comparison, growth in the Nifty Smallcap 250 – TRI was at 28.3%, while it was 25.4% in the Nifty Midcap 150 – TRI, and 12.6% in Nifty 50 – TRI during this period. Over the longer time frames too, the micro-cap segment has outperformed all other segments in the equity market.

What are Micro-cap stocks?

There are over 5,000 companies listed on the BSE, and more than 2,000 companies are listed on the NSE. SEBI defines large-cap stocks as the top 100 stocks in terms of market capitalisation, mid-cap stocks as those ranking 101st to 250th, and small-cap stocks as those ranking 251st onwards.

While SEBI has not defined micro-cap stocks, they are usually considered as companies ranking beyond the top 500 in terms of market capitalisation. These companies generally have a market capitalisation of less than Rs 5,000 crore.

The biggest micro-cap stock according to AMFI’s classification list, i.e. 501st company, as of June 2023 is HG Infra Engineering with a market capitalisation of Rs 5,226 crore.

Micro-caps outperform over the long run

Data as of September 21, 2023
Base taken as 10,000
(Source: ACE MF, niftyindices.com, data collated by PersonalFN) 

Mutual Funds are turning attention towards micro-caps

Currently, Micro Cap Funds do not have a separate sub-category under equity mutual funds. However, the recent rally has attracted some mutual funds towards the segment, and they are now looking to capitalise on opportunities beyond small-cap stocks.

In June 2023, Motilal Oswal Mutual Fund launched India’s first passively managed scheme, Motilal Oswal Nifty Microcap 250 Index Fund, offering exposure to micro-cap stocks. The fund tracks the Nifty Microcap 250 – TRI index which invests in stocks ranking 501st to 750th in terms of market capitalisation. It has mopped up Rs 324 crore as of August 31, 2023.

More recently, Bandhan Mutual Fund has filed draft papers with SEBI to launch India’s first actively managed Micro-cap Fund.

Top portfolio constituents of the Nifty Microcap 250 index

Data as of August 31, 2023
(Source: niftyindices.com) 

Apart from this, several actively managed schemes, particularly in the Small Cap Fund category, have exposure to micro-cap stocks. As of August 31, 2023, the value of micro-cap stocks held in mutual fund schemes stood at around Rs 56,000 crore.

Some of the micro-cap stocks that mutual funds currently hold are Delta Corp, Gabreil India, V-Mart Retail, Gateway Distriparks, Dodla Dairy, Ahluwalia Contracts, Sharda Crop Chem, Hawkins Cookers, Gokaldas Exports, Dhanuka Agritech, Nilkamal, Rossari Biotech, and La Opala RG.

AMC-wise, Quant Mutual Fund has the highest exposure to micro-cap stocks (stocks with a market capitalisation of Rs 5,000 or below) at around 10.4% of its equity AUM, followed by ITI Mutual Fund, Taurus Mutual Fund, Bank of India Mutual Fund, WhiteOak Capital Mutual Fund, DSP Mutual Fund, and Bandhan Mutual Fund.

Mutual Fund Houses that hold higher allocation to micro-caps as a percentage of their equity AUM

Data as of August 31, 2023
(Source: ACE MF, data collared by PersonalFN) 

Are Micro-cap-focused mutual funds worth investing?

Although all equity investments are risky, the risk amplifies manifold in the case of micro-caps compared to large-cap, mid-cap, and even the small-cap segment. Below are the reasons why it is important to be extremely cautious while considering investments in the micro-cap segment:

1) Limited information

The top 500 companies account for more than 90% of the overall market capitalisation of the BSE. These top 500 companies are actively tracked by market experts and analysts, including mutual funds and Foreign Institutional Investors (FIIs). As a result, there is abundant information available from this space to make informed investment decisions. On the flip side, due to a lack of focus by analysts, there may not be enough data available for thorough research for stocks in the micro-cap segment.

2) Higher downside risk

While the returns on micro-caps have been extraordinary in the long run, these stocks are prone to high volatility and downside risks. Historical data suggests that micro-cap stocks can experience relatively deeper and longer drawdowns compared to mid-caps and small-caps when bears grip the market. This especially holds true in the current market environment where the valuations have soared significantly and may have run ahead of the fundamentals. Furthermore, they are more vulnerable to market sentiments and speculations, resulting in higher fluctuations in stock prices.

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3) Long list of wealth destroyers

The list of winners in micro-caps is much lower compared to bigger and well-established businesses. This means that not all micro-cap stocks can turn out to be multibaggers. Remember that most micro-cap stocks can rally during bull market phases even if they lack earnings growth. Only a handful of quality stocks from the large universe of micro-caps having a strong margin of safety can turn out to be high alpha creators in the long run. The rest may see a sharp decline during uncertain and pessimistic market environments and may even face risk to survival.

4) Liquidity concerns

Since micro-caps are usually under-researched, the trading volume of these stocks is generally low, which makes them less liquid. This can make it difficult for investors and mutual fund managers to take advantage of various investment opportunities or to buy/sell securities as per their wish. Besides, there may also be concerns related to manipulations of stock prices, corporate governance standards, and the long-term viability of the company to survive hardships.

To conclude:

Historically, the equity market has witnessed several micro and small-sized stocks grow from little-known names to index heavyweights. However, as mentioned earlier, the higher rewards in the micro-caps come at a relatively higher risk.

Thus, investors should not see micro-caps as an avenue to make quick gains. Instead, they should be aware of all the associated risks.

Investment in micro-caps is only suitable for seasoned investors who have a very high risk appetite and are looking to boost portfolio returns by adopting aggressive investment strategies. Such investors may consider allocating up to 5-10% of their equity mutual fund portfolio in micro-cap-oriented mutual funds. They may also consider Small Cap Mutual Funds and other funds such as Multi Cap Funds and Mid Cap Funds that have substantial allocation to micro-caps. On the other hand, risk-averse investors should steer clear from having any exposure to micro-caps.

This article first appeared on PersonalFN here