Home >Money >Personal Finance >Opinion | Good research may throw up a few multibaggers in the micro-cap space

As the benchmark indices stay near all-time highs, a rising concern among investors is poor performance in parts of the market. Through 2018 and 2019, the small- and mid-cap space suffered a sharp fall in valuations. This was worsened by an earnings contraction in many companies. This led to a double whammy for investors in several companies who were affected by the twin impact of lower valuation multiples and contracting earnings.

The compression in valuations has not just been restricted to companies with poor business performance. Even companies with stable earnings have been sharply impacted by this fall. Investors are stumped as to what caused this aversion to buy good small-caps even when they are available at attractive valuations. Investors are perplexed by the incessant selling in several companies with no explicable business-related reason. The sharp contraction in valuations happened both with and without valid reasons, a distinction which investors are still struggling to make.

The genesis lies in the categorization of mutual funds and criteria laid down for companies in October 2017 to qualify as small-caps and mid-caps. The move led to the gradual polarization of the market towards the top 500 companies. Most institutional investors have been selling companies which fell outside the ambit of their funds’ categories. This led to sustained selling of several stocks. It did not help matters that some of these stocks were widely held by institutional investors. Mutual funds suddenly rushed to the exit doors to ensure that their schemes’ integrity was protected. While this move was well-intentioned, the institutional rush to exit illiquid stocks has caused a sharp valuation contraction in several companies. The reasons are fairly obvious. There weren’t enough ready buyers for these large parcels of shares. Funds were forced to continuously sell these shares in the market. The impact of selling in a falling market chased away potential buyers. Funds sold the shares even as there were no buyers and prices fell continuously.

This led to a free fall in several stocks despite their reasonable fundamentals. Now, nobody wants to invest in stocks which don’t fall under a clear marketable category of the market. This can exert further downward pressure on stocks which are outside the popular categories of equity funds.

The primary space where this pressure seems unabated is the micro-cap space. Stocks which no longer qualify as small-caps go on to become micro-caps. The micro-cap category was much celebrated before the crash of 2018. Mutual fund schemes and portfolio management services (PMS) had a stellar performance until January 2018. But as the categorization took full effect, these schemes suddenly found themselves in a difficult spot. They could no longer find the desired liquidity, and the impact cost of both buying and selling these stocks soared. This began to affect returns. Further, investor confidence was also sharply dented as serious corporate governance issues in several companies came to the fore. A palpable institutional aversion to micro-caps was seeded in the troubling events of 2018. The fact that valuations were at historic highs and often at a premium, even to the Nifty, was a serious deterrent. As institutional investors completely moved away from this space, the selling simply could not find buying interest to that extent. Or, the interest could only be found at throwaway valuations.

Currently, the micro-cap category hardly has any institutional following and the two-year performance of this category has been uninspiring. The economic slowdown and the sharp slump in credit to smaller businesses have not helped matters either. But, micro-caps as a category will remain a feeder for the small-cap category and beyond.

As valuations slump to decadal lows, some micro-caps will become attractive investment propositions. The lack of near-term growth in select, neglected sectors like services and capital goods has made several companies trade at abysmal valuations. The discerning investor can still find a few companies which could turn out to be good medium-term bets. In the ignored and oversold micro-cap space, good research can throw up a few multibaggers over a three-to-five-year period. More importantly, one-way selling by institutional investors may actually make it easy for individual investors to notch up significant positions in companies with potential. Conviction and time will deliver big from here.

Shyam Sekhar is chief ideator and founder, iThought

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