Why investors should consider these 20 micro-cap stocks

Harish Krishnan, a fund manager at Aditya Birla Sunlife, is high on micro-cap stocks these days.“Earnings (TTM or trailing 12 months) of micro-caps have moved from ₹50k crore to ₹83k crore (1.65x growth) over last three years — market cap of these micro-caps have moved from ₹8 lakh crore to ₹24 lakh crore (close to 3x growth)!” he recently tweeted. Earnings (TTM) of micro caps have moved from 50k cr to 83kcr (1.65x growth) over last 3 years - marketcap of these microcaps have moved from 8 lakh crores to 24 lakh crores (close to 3x growth)!

(Source: raw data from ISec, all data only for profitable companies in dataset)

— Harish Krishnan,CFA (@hktg13) July 14, 2024 Krishnan’s enthusiasm mirrors the fact that for the first time, micro-caps are eating into the market-captalisation share of large-cap companies. At present, the retail segment is the bulk investor in many of these companies even though the micro-cap index looks expensive.The Nifty micro-cap 250 index is trading at a P/E (price-to-earnings) multiple of 32x, while the Nifty 50 index is at 23x. Since they are overvalued, many of these companies might not generate great returns for investors. Still, the micro-cap segment is on a strong wicket and investors with risk appetite can still find opportunities here.Micro-caps are defined as companies that are below the top 500 slot in terms of market capitalisation. Krishnan explains the emergence of this category primarily because of the formalisation of the Indian economy.In another tweet, he writes about how small companies are eating into the market-capitalisation share of large-caps. In 2001, the market-capitalisation share of large-caps in the total market capitalisation of the Indian markets was at around 90%. Today, this number has come down to 65%.If this is not blowing your mind, wait. He has more data. The earnings share of the top 100 companies for the same period is down from 77% to 72%.The big divergence happened from September 2023 (for the first time in 25 years) where the market-capitalisation share of micro-cap companies is higher than their earnings share.The absence of institutional investors doesn’t give a good feeling but that’s how the micro-cap segment works. Institutional investors require some size and liquidity to enter or exit companies.Zebras in lion countryRisk-taking retail investors can look at some fundamentally strong micro-caps at their current valuation. But while investing in these companies, retail investors should keep in mind some of the principles laid out by Ralph Wagner, one of the greatest small-cap investors and the author of Zebras in Lion Country.In his book, Wagner argues that when zebras move out of the herd to find fresh grass, they also risk the danger of being hunted by a lion. So, it is a risk-and-return tradeoff. While Wagner warns about this risk, he also says that small-cap companies do give great returns if you pay a reasonable price for the stocks.Wagner believes that investors should go in for companies that are building mass-market products, anything from gaming to healthcare. Looking at India’s current growth trajectory, the big bets in small-caps are construction, real estate and chemical companies. But the big boost is in NBFCs (non-banking financial companies) or finance companies.The growing lotET Prime looked at micro-cap companies that have grown the fastest over the past year (FY23-24). We filtered the list further and took those companies whose net profit growth for the past year was higher than the revenue growth. From that list, we sorted 20 stocks based on the descending order of five-year annual growth rate. We wanted to be sure that these companies have been listed for the past five years and are growing. medium111854508 medium1118545301. According to the latest data available on Ace Equity (it is FY23 for some and FY24 for others), all the top 20 companies have a good RoCE (return on capital employed) at or above 15%, with the exception of Anant Raj and Electrosteel Castings at around 10%. The highest RoCE is for Sharda Motors and Fineotex Chemical at around 40%.2. Most of these stocks have a high retail holding. Mutual funds hardly hold a substantial stake in these companies except for Ahluwalia Contracts, where mutual funds hold a 24% stake. SBI SmallcapFund holds a 7% stake followed by Axis MF at close to 6%.Over the past few quarters, mutual funds have slowly been reducing their stake, while retail investors have been increasing their holdings in the company. The latter currently hold a 4% stake in the firm.Ahluwalia Contracts is a civil contractor with experience of more than 43 years in the industry. It is among a select group of three-four contractors who are pre-qualified to bid for most of the mega building projects in the country.3. Retail investors, at 30%, hold the highest stake in Zen Technologies. Mutual funds hardly hold 0.09% stake in the company. The stock has run up 129% in the past year and more so in the past month at 21%. The Hyderabad-headquartered company designs, develops and manufactures combat training solutions for defence and security forces globally.4. The stock that has moved up the most on the list in just a month is Sharda Motors. The stock is up 47% in a month and 212% in a year. Mutual funds purchased a stake of close to 8% in the company in the June quarter. Prior to this, there was hardly any mutual fund holding in the company. The company manufactures auto components and equipment, including exhaust systems and suspension systems.5. The stock that is trading at a lower P/E than its 200-day average is Spandana Sphoorty, a microfinance lender, at 11x. The stock has remained a massive underperformer against the benchmark Nifty. While most stocks are up in the bull run, this is one of the few stocks that has given negative returns.6. Speciality chemicals have also made it to the list with Fineotex Chemical. The company has reported low revenue growth for FY24. Fineotex is a small company in terms of revenue and was therefore able to garner 10% revenue growth rate but in absolute terms it was just about ₹50 crore.7. Two realty stocks — Ganesh Housing and Anant Raj — have made it to the list. While Anand Raj is a real estate developer in Delhi National Capital Region, Ganesh Housing is engaged in the business of construction and real estate development in and around Ahmedabad. Ganesh Housing trades at a P/E lesser than the Nifty Realty index and Anant Raj trades higher than the index. Both these companies have reported solid revenue growth for FY24. Both have low RoCE.8. IIFL and Spandana Sphoorty figure on our list. While the IIFL stock has given 182% return over the past year, Spandana Spoohrty has remained flat.