How to Find the Best Microcap Stocks in India

There are 6,000+ listed entities on the Bombay Stock Exchange (BSE).

Out of these, the top 500 companies form approximately more than 90% of the overall market capitalisation of the BSE.

As such, analysts, fund managers and foreign investors (FIIs) focus on stocks from this space. To put it differently, there is abundance of information available on such companies.

But what about the remaining stocks? Are they not investment worthy?

Microcap stocks, small cap stocks and penny stocks are more or often used interchangeably. However, there are key distinctions which investors often forget while bifurcating.

Microcaps and smallcap stocks refer to the market capitalisation of a company.

On the other hand, penny stocks refer to the price of the stock.

As of now, there are no hard guidelines for determining microcaps, smallcaps, and penny stock. It's important for investors to understand the differences between microcaps, smallcaps, and penny stocks to estimate the possible returns on their investment and risks.

What is a microcap stock?

A microcap stock is a publicly traded company that has a market capitalisation which is lower than small, mid, and large-cap stocks.

While the stocks which rank below 250 on marketcap are all considered smallcap, there is an index which distinguishes smallcaps and microcaps.

It's the Nifty Microcap 250 index.

This index has the top 250 companies beyond the NSE Nifty 500 index.

It's made up of microcap companies ranked from 501 to 750, based on of their average full market capitalisation.

What are the features of microcap stocks?

Investing involves a certain amount of risk and when it comes to microcap stocks, the risk becomes even more.

In case of microcaps, most of the companies are new to the mix. They may not have significant revenues or profit growth.

Microcap stocks are more risky compared to bluechip or mid-cap stocks. Also, they tend to be extremely cyclical.

Suppose you invest in a microcap company as a speculative bet. That company goes on to post extremely good results. Owing to this, you make hefty gains on your investment.

But this speculative bet can quickly turn into a failed one in the case of microcaps. Profits and revenues can fall significantly and this, in turn, can erode your wealth by 80-90%.

A big challenge here is that large mid-cap companies have the ability to make comebacks. Microcaps don't but here's the crux.

Microcaps present a huge growth potential.

Microcaps are like chocolates. Very tasty and tempting yet they can be bad for health. Just like how connoisseurs can't keep their hands off chocolates, analysts can't stay away from the best microcap stocks.

It's very typical for a good microcap stock to turn a multibagger in a matter of months.

For finding such multibaggers, one needs to follow a certain process.

One must understand the company's financials, its business strategy, and future prospects before investing.

How to screen the best microcap stocks?

It's very critical to avoid unnecessary risks and speculative bets when it comes to microcaps.

Here are some broad guidelines to pick multibagger stocks in microcap space.

• Economic Moat

  The dictionary defines a moat as a deep, wide ditch surrounding a castle, fort, or town, typically filled with water and intended as a defence against attack.

  In investing, it refers to a business's ability to maintain its competitive advantage over its peers to protect market share and ensure sustained profits. It's what allows a business to earn high returns on capital over time.

  The wider the moat, the stronger the business. If the moat is weak, ultimately, competition will spoil the game, erode returns, and take away market share and profits overtime.

  Moats could come from having a cost advantage, brands, exclusive licensing or patents, network effects, and higher switching costs.

  But remember, the presence of one or many of these do not ensure great returns.

  A true moat needs to stand the test of the time.

  In the absence of that, one might end up with companies like Kodak. It used to be the market leader but could not stand up to the technological disruption from digital cameras. The moat did not just get eroded, it was completely wiped away.

  A true moat gives a business scalability, and with every growth milestone crossed, it gets strengthened further.

  Think about Coca Cola. The company has been around for decades.

  There are businesses that compete with it. Yet Coca Cola has not just survived but expanded its market share multifold.

  The more it grows, the more difficult it becomes for new or existing players to compete with its distribution network.

• Management Quality

  Investing in a stock is not buying a share with a price tag. It's like owning a part of the business. The management are your business partners.

  Unlike largecaps, which run on auto pilot, managements can make or break a microcap company. You need to be highly discerning about who you want to partner with.

  So, what kind of partners should you look for?

  You're looking for three things, generally, in a person, says Warren Buffett. Intelligence, energy, and integrity. If they don't have the last one, don't even bother with the first two.

  That is as succinct an advice that could ever be given while assessing the management quality of the businesses you may want to invest in.

  The quality of management does not get captured in quarterly or even year-on-year (YoY) profit growth numbers. You need to look deeper. I'll come to it later.

• Promoter Stake and Debt

  Once the management screening is done, promoter's stake comes into play.

  A high promoter stake shows confidence in the business. Promoter holding and pledged shares should be considered.

  Debt figures should also be considered. High debt means the interest outgo is huge, which can be a big drag. If the company is unable to generate enough cash to service its debt, it's at risk of bankruptcy.

  Companies with low debt equity ratios can more easily survive periods of poor performance.

• Margin of Safety

  Margin of safety is what differentiates a good business from a good investment. The margin of safety is the difference between your anticipated profitability and your break-even point.

  For calculating margin of safety, it is equivalent to current sales minus the break-even point, divided by present sales.

  A reduced percentage of margin of safety might drive the business to make other decisions, such as cutting its expenses.

  While increased percentage of margin of safety will comfort a business and it will be safeguarded from sales inconsistency.

  Always ask how much a company is worth and never overpay. Margin of safety ensures that you buy a stock only when it trades at a reasonable discount to its true value.

• SWOT Analysis

  Simply put, SWOT stands for Strengths, Weaknesses, Opportunities and Threats.

  One should look at SWOT as an important step in the analysis of a company.

  Analysis of SWOT will help in identifying the key attributes that can make a company an attractive investment. It's also important to look at all four attributes together.

  A comprehensive SWOT analysis gives a key insight about the company's strategy, competitive advantage, and competitive intensity in the sector.

  It's a necessary tool for fundamental evaluation of the company an investor is looking at.

• Time Frame

  Microcaps tend to be far more volatile than largecaps. Now this doesn't mean one should steer clear of this space.

  It's just that investors should select a time frame as to how long can they hold the stock.

  There will be large up and down swings in the share price. Stop losses are often recommended.

  Agreed that stop loss is essential in case of microcaps as stocks tend to fall even 80-90% in a matter of months.

  But if one focuses on the business fundamentals, growth prospects, management, and valuations, a good quality microcap stock will do well in the long run.

  Consider your investment in microcap stocks as the tree that you have just planted. Now obviously, they will take a few years to grow and then you will be able to reap the benefits.

  Generally, one should focus on good quality microcap stocks with a time frame of 3 to 5 years.

How much should one invest in microcaps?

As discussed earlier, microcaps are more vulnerable to market sentiments and speculations, and hence volatile as compared to bluechips or midcaps.

Further, the success ratio in microcaps is lower as compared to bigger businesses.

Not all smallcaps turn out to be multibaggers. It's not unusual to see sharp declines in a short time frame when bears take grip of the markets.

That limitation is more than compensated when one picks quality microcaps for the long term, with strong margin of safety in valuations.

With an optimum asset allocation, one can use microcaps to the best advantage - making asymmetric payoffs from the upside, while not losing much in case of a downside.

According to us, in a scenario of ideal allocation of funds, microcap stocks should not comprise more than 10% of one's total equity portfolio.

This means that the corpus that one sets aside for microcaps should not be more than 10% of the total money allocated towards equities.

To conclude

While we can't make any stock recommendations through this article, if you follow the points shared above, you are likely to come across good quality microcap stocks in your investment journey.

Eicher Motors, Avanti Feeds, Astral Polytechnik and the likes were tiny microcaps two decades ago. Skip forward to present, they are the market darlings today.

Of course, not every microcap company will emerge to become a giant.

If you don't want exposure to microcap stocks, you can indirectly take exposure by investing in a micro or small cap focused mutual fund or an exchange-traded fund (ETF).

Rather than making 'speculative bets', you could consider subscribing to our premium recommendation service, Microcap Millionaires, a service based on the principles of Benjamin Graham i.e. deep value investing.

This service follows a system that screens stocks from the microcap universe in their journey towards becoming a multibagger.

Happy Investing!

Here are Links to Some Insightful Equitymaster Articles and Videos on Microcaps

• Identifying stocks: Do's and Don'ts
• Emerging Trends in Smallcap Investing in 2021
• Charlie Munger Waited 50 Years to Find the Perfect Stock. But There is an Easier Way
• The 3-Word Secret to Earning Incredible Returns
• These Ratios Can Get You into the Most Promising Penny Stocks
• How to Evaluate a Stock in India