Micro-cap stocks' rally draws mutual funds. Should you invest? (2024)

Despite pricey valuations, Indian mutual funds’ exposure to micro-cap stocks has risen at a quicker pace compared to the growth of overall equity assets, raising concerns from a risk perspective.

Data available with the Prime MF Database showed that the value of micro-cap stocks in all the mutual fund schemes has risen from Rs 45,482 crore in September 2022 to Rs 60,229 crore in August 2023, a rise of 32 percent during the period. This rise also reflects the sharp rise in stock prices of small- and mid-sized companies during this period.

During the same time, the overall equity assets under management (AUM) of the Rs 46.33 lakh crore mutual fund industry rose by 22 percent to Rs 22.07 lakh crore.

While investing, mutual funds have to stick with the classification of market capitalisations laid down by the Securities and Exchange Board of India (SEBI) in 2017. Large-caps are defined as the 1st to 100th companies in terms of full market capitalisation, mid-caps as the 101st to 250th companies, and small-caps as the 251st company onwards in terms of full market capitalisation. This list is updated twice a year by the industry body, the Association of Mutual Funds in India (AMFI).

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While there is no SEBI-defined classification of micro-caps, companies that come after the Nifty 500 in terms of total market capitalisation are usually considered micro-caps.

As per the market-cap list issued by AMFI in June 2023, Rolex Rings Ltd had the least market-cap in the Nifty 500 at Rs 5,225.98 crore.

How micro-caps have fared

Over the one-year period, the Nifty 100 Total Return Index (TRI) has gained 10 percent. Compared to this, Nifty Micro-Cap 250 TRI is up 44 percent and Nifty Small-Cap 250 TRI has risen 28 percent.

With the rally in micro-cap stocks, this zone’s valuations have become pricey in terms of the price-to-earnings (P/E) ratio (see table). A high P/E could mean that a stock's price is high relative to earnings and possibly overvalued.

Experts say that over the medium to long term, micro-cap stocks have outperformed the Nifty 50 index by a wide margin. Therefore, from the medium to the long term, they continue to create wealth and are one of the best performers across all equity classes.

“However, it's important to acknowledge that the micro-cap segment seems to be getting a bit ahead of itself in terms of valuations. In light of this, investors should be careful and choosy when navigating this space, as there are quite a few stocks that appear to be trading at prices that are higher than justified,” said Shrey Jain, Founder and Chief Executive Officer (CEO) of SAS Online, a discount broker.

New funds on the horizon

Thanks to the rally in micro-cap stocks, the smallest market-cap zone has caught the fancy of mutual fund houses.

In June, Motilal Oswal Mutual Fund launched India’s first passive scheme, which offers exposure to micro-cap stocks by investing in companies from the 501st to 750th spots in terms of market capitalisation. The Motilal Oswal Nifty Microcap 250 Index Fund mopped up Rs 120 crore during its new fund offer period. The AUM of the scheme rose to Rs 324 crore as of August-end.

Now, Bandhan Mutual Fund is looking to launch India’s first active scheme that invests in micro-cap stocks. As per the draft scheme information document filed for Bandhan Microcap Fund with SEBI, the asset management company (AMC) defines micro-cap companies as those companies that have a market capitalisation below the 50 percent of the market capitalisation of the lowest midcap companies as per AMFI published data.

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As per the AMFI list of the average market capitalisation of listed companies during the six months ended June 30, 2023, Whirlpool of India had the lowest market cap at Rs 17,409 crore. By this definition, the fund will aim to invest in companies with a market cap of Rs 8,705 crore and below.

Sirshendu Basu, Head of Products at Bandhan AMC, said, “The number of companies above the Rs 2,000-crore market-cap currently is around 680 (as per AMFI June 2023 data), which is expected to move to about 1,000 over the next few years. Our strategy in the micro-cap space is based on emerging sectors, potential future drivers, and the new listings from the start-up ecosystem put together can potentially do well for investors who have a high-risk appetite.”

Lack of liquidity is a big issue in the micro-cap space. In the small-cap category, liquidity is poor and impact costs are high compared to large-caps and mid-caps. This has forced some small-cap funds to curtail fresh investment in these schemes.

Bandhan Microcap Fund may also look at the ‘long-tail’ strategy, which will entail many stocks in the portfolio, helping address liquidity issues and diversifying the risk. A long tail, in fund management parlance, also refers to a large number of stocks, each with a 1-2 percent or lesser holding in the scheme’s portfolio.

How existing funds are placed

Small-cap funds, which have the highest risk matrix of all the funds based on market caps, have the highest exposure to micro-cap stocks.

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Data available with the Prime MF Database showed that of the top 10 small-cap funds based on AUM, DSP Small Cap had the highest exposure to micro-cap stocks at 27 percent as of August-end. This was followed by Quant Small Cap at 22 percent.

On the other hand, based on value, Nippon India Small Cap had the highest exposure to micro-cap stocks among the top 10 small-cap funds at Rs 5,952 crore, followed by Rs 4,483 crore in HDFC Small Cap.

The market cap list issued by AMFI in June 2023 was considered for this study. As per data, the 501st ranked company was H.G. Infra Engineering, with a market cap of Rs 5,225.41 crore.

Overall, 24 small-cap funds had a total exposure of Rs 30,219 crore in micro-cap stocks.

Further, Ahluwalia Contracts had the highest exposure by small-cap funds at Rs 870 crore, followed by DCB Bank at Rs 786 crore and Orient Electric at Rs 777 crore.

Risky affair

Data compiled by Moneycontrol showed that on a long-term basis, the Nifty Micro-Cap 250 TRI registered a spectacular show by gaining 574 percent from its March 2020 lows. Meanwhile, Nifty 50 TRI, Nifty Mid-Cap 150 TRI, and Nifty Small-Cap 250 TRI gained 176 percent, 275 percent, and 321 percent respectively, during the same period.

SAS Online’s Jain said, “While returns on investment in the micro-cap space could be higher in the long run, these investments are highly volatile and prone to fluctuations in the short term. Cycles have become shorter and sharper, and to ensure long-term survival and wealth creation, it's crucial to remain vigilant not only in the near term but also in the short term.”

Historically, small-cap and micro-cap segments have experienced deeper and longer drawdowns.

Experts feel that while the micro-cap segment is a good hunting ground for future performers, the opportunities could be few and far between.

“Micro-caps cannot be viewed with the same lens as one would view mid-caps and small-caps because the latter two can be considered a basket and there's some sort of umbrella that you can put all of them under. But this equation gets diluted as you move towards the deeper end of the market, which is micro-cap,” said Nirav Karkera, Head of Research at Fisdom.

Opportunities are available in the micro-cap space only on a specific scrip level, as there is no basket buying happening here. “No one out there is suggesting a buy on micro-caps as a basket or as a segment.”

Investing in micro-cap stocks can offer potential rewards, but it also comes with several risks that investors should be aware of. Lack of liquidity, volatility, limited information on companies, a higher risk of fraud, business risk, a lack of institutional interest, long-term viability, and market manipulation are key factors that make micro-cap stocks much riskier than large-cap stocks.

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Despite their past performance, this is not the first, second, or even third mutual fund scheme you should buy when you are starting your investment journey. At best, micro-cap funds can be a part of your satellite portfolio; they should ideally not be a part of your core portfolio.

Dhuraivel Gunasekaran contributed to this story.