‘Only Time To Choose Microcaps Is When Entering A Bull Market': ICICI Securities' Vinod Karki On The Microcap Frenzy

A report by investment bank Goldman Sachs early last month said that India had produced the largest proportion of ‘multi-bagger' stocks among the top 10 emerging and developing markets.

The analysis was based on 6,700 stocks across 10 markets, with India, Korea, Brazil, South Africa, China, and Taiwan among emerging markets; and the US, Japan, Europe, and Australia among developed markets. Goldman Sachs identified 269 stocks listed on NSE 500, which generated more than 10 times returns over the last two decades, making up 54% of the index.

Notably, at least half of these multi-baggers had a market capitalisation of $50 million or less than Rs 400 crore going by current rates. Which brings us to microcaps - stocks that hover in the Rs 500-1,000 crore market capitalisation range today.

Several mutual funds that started collecting funds for microcap or smaller cap schemes have closed or are closing their doors. In the last week or so, Nippon India Mutual Fund - which is advertising quite heavily right now and Tata Mutual Fund stopped lump sum investments into their funds.Both are allowing systematic investment plan-based investments which come in smaller but predictable doses from usually smaller investors.

The reason they don't want large chunks of money is they don't want to be saddled with more money than they can invest, at least judiciously. And obviously, there are not that many liquid options.

This brings up some fairly obvious questions – Are microcaps just a new name for what Goldman Sachs was calling small caps two decades ago? And by extension, is it a way of approaching the market differently since mutual funds and brokerages have to find new ideas to pitch to customers and clients? Most importantly, is there any steam left in this microcap wave or is it coming to an end?

Govindraj Ethiraj, Editor, The Core, spoke to Vinod Karki, Equity Strategist at institutional broker ICICI Securities, to understand the microcap wave.

Here are edited excerpts from the interview:

What are micro caps?

Micro caps, if you go by the classification methodology that's been given out, the companies which, if you were to rank companies based on market cap, they would start from the 501st company. We have put a limit till the 1,000th company. Any company between market cap rank of 501 to 1,000 can be classified as a micro cap. And typically these companies would be having market caps of a few thousand growth and less.

Would you say that this definition has held or been used in the past as well?

That has not been exactly that way. The MC gave out these classification rules a few years ago if you remember. And micro cap actually is not defined properly. It is actually a subset of small cap. Anything which is beyond 250 companies becomes small cap. But if you look at the NSC index, the NSC micro cap 250 index, it is also looking at companies beyond 500 market cap rank. We have also been defining micro cap similarly for quite some time, but we take it from the 501st rank to 1,000th rank.

What would you say is a good period for estimating return? For instance, let's say if you look at some of the big gainers today in the markets and I mean which are obviously all large cap. I'm assuming you would have to go back at least 15-20 years to have spotted them as micro caps. Would that be correct?

Well, I would say 10 years is a reasonably good time, 10 and beyond for some smaller micro company to become somewhere in the mid to large area. The darlings of today, Bajaj Finance, Bajaj Finserv if you look at them in 2011, '12, they were clearly in the small cap category at that point in time. I think 10 years and beyond is a reasonably good time for allowing a smaller cap or a micro cap company to really expand into a mid or a large term.

Is there any thread that connects all of them or some of them at least in terms of the industry or sector they belong to or the kind of companies they are?

See, if you look at the economic recovery, what we've been observing, the post-pandemic economic recovery has been largely from the investment cycle and the manufacturing activities and the real estate cycle, then a credit cycle leading up. And what we observe is that the micro cap space, unlike the large cap NIFTY index, has a significantly higher voltage to the industrial sector basically within the micro cap index. More than 50% weight is from the industrials and almost 18% is from discretionary consumption. And very less of the typical defensive sectors like Staples, IP, those kinds of sectors basically. I think that's one common theme, sectorially if I were to look at it.

As you look ahead, now there are two kinds of ways I guess investors would love to get into this. Obviously they would want to invest directly. What's the cautionary note you have for them? And secondly, some mutual funds that said they were going to focus on this space are closing their doors because I'm assuming they're not seeing enough opportunity or enough liquidity. Is there a contradiction of sorts there?

In our analysis and research, what we realised is that what is a boon for this segment in an upcycle becomes its curse. What I mean by that is, first of all, as I mentioned a lot of these, the bigger weight is in cyclicals. Cyclicals typically do well when you are in an expansion mode in the economy, industrials and discretionary consumption and things like that.

And second is these micro caps have very low liquidity. The build and ask spread is always high. If there is a frenzy to buy, the prices are built up significantly higher, which I reckon will happen only when you have an environment where these assets are in demand. That will result in these prices spiking if you were to enter a bull market because the liquidity will be less, the assets will be in demand and therefore, the price runup will be significantly higher.

Now look at it from a bear market scenario. In a bear market, what will happen is first of all the cyclical assets, cyclical industrials really see the demand impact impact in the economy, the first ones to get impacted severely. And second is in the second year market, the liquidity will always see an issue for such assets.

While if you want to sell it, it will be even more difficult to sell it. The best time, the only time rather, to choose this asset class would be when you are getting a sense that we are entering a bull market which is supported by a broad-based investment cycle and the economic upturn.

Do you believe that that's somewhat the phase we are in, which also triggered the report to start with?

Yes, absolutely. We have been over the last year or so, telling our clients that the post-pandemic economic recovery in the GDP pillar to break the GDP number, is largely driven by gross fixed capital formation. Large part of it is being contributed by the decadal upturn in the real estate cycle and the massive central government CapEx.

States have been behind, but now they are expected to pick up given that the fiscal deficit of the states is under control and their revenues are rising. And corporates have also started picking out CapEx that we have seen in FY23 to some extent. It is turning out to be a broad-based epic cycle like we saw between 2003, '04 till about 2010, '12 looks like we are beginning to see that kind of environment.

In this environment, and the bull market also showing signs of a broad-based market rally, unlike the pre-COVID rally which you have seen, they've been very narrow. I mean the five, six stops were contributing to the bulk of the index scales. That era is behind and we are seeing more broad-based performance.

I think the combination of what's happening in the economy and what's happening in the market, they should both be reflecting each other. One should not be at odds with the other. I think that is confirming and that's why we think that, given that we still have some cushion for micro caps over large cap valuation. And in the past, we have seen that in a bull market the valuations of micro caps can actually reach the large cap at the peak of the cycle and we still have 150, 200 bps of spread left, I think there is a chance for this asset cluster, no problem.