Headline numbers can be misleading: The case for granular analysis in microcap investing

​​​​​​​This article is authored by Pawan Bharaddia, Co-Founder of Equitree Capital

William Sharpe, the Nobel laureate economist, famously remarked, "The problem with averages is that they don't tell you very much about the specifics."

The weightages of a few companies generally tend to distort the averages. With the markets hitting new highs, the bugle of high valuations has been growing loud – more particularly for the small and Mid-Cap stocks. However, when one looks at the NSE Small Cap index valuation, it currently trades at 30.21x (TTM basis) which is in line with its 10-year average of 30.48x! However, when one looks at the average market cap of the index it stands at Rs. 23,170 crore which is not small in the first place!

If one were to look at the valuation of companies in the range of Rs. 200-5000 crore (which is Small Cap in the true sense), this trades at a valuation of 26x (TTM basis) which is actually at a 17 per cent discount to its 10-year average of 31x.

Such granular analysis of the microcap segment reveals a far more compelling narrative that aggregate data fails to capture.

Beyond the Surface: Unveiling the Microcap Landscape

A deeper dive into the Small-Cap universe uncovers significant variations within the sector. It is interesting that while the headline numbers across the entire Small and Micro cap companies universe show an unimpressive 2 per cent CAGR in earnings growth between 2017-2024, a more detailed analysis reveals that over 300 companies within this genre (Rs 200 crore to Rs 5,000 crore) have demonstrated a robust 30 per cent + CAGR.

This stark contrast highlights the importance of examining specific segments rather than relying on aggregate data.

Sectoral Insights: Dissecting the Microcap Universe

Manufacturing Segment

Within the manufacturing segment, microcap companies have shown significant growth. The median PE of the microcap segment aligns closely with the 2017 level, with market capitalisation and profit after tax (PAT) growing at a 9 per cent CAGR. Notably, 42 per cent of companies in this segment have doubled their PAT over the past six years, and 20 per cent have posted more than a 30 per cent PAT CAGR​​. Government initiatives such as the Production Linked Incentive (PLI) scheme have further bolstered this sector, leading to increased investments and capacity expansions.

Consumer Segment

The consumer segment also paints a promising picture. Over the last six years, aggregate profits have doubled, and the median PE ratio of the microcap segment remains stable compared to 2017 levels. Within this segment, 46 per cent of companies have doubled their PAT, and 22 per cent have achieved more than a 30 per cent PAT CAGR​​. Government policies aimed at boosting consumer spending, such as tax cuts and subsidies, have also played a crucial role in this growth.

Infrastructure Segment

On an aggregate basis, the infrastructure segment seems to have faced challenges, with negative growth during FY17-24. This performance again gets skewed due to significant write-offs and underperformance by a few companies. However, there are notable exceptions within this segment.

For instance, one company within Equitree's portfolio has seen its profits increase over threefold during this period​​. The government's focus on infrastructure development, highlighted by increased budget allocations and ambitious projects like Bharatmala and Sagarmala, has provided a significant tailwind for the sector. Growth will be led by continued government outlay for infrastructure, anticipated revival in private capital expenditure, PLI-led investments, EV infrastructure, and data-centre-related investments.

Volatility ≠ Risk: The Microcap Paradox and Market Opportunities

While small and microcap investing is often labelled as a risky gamble due to its inherent volatility, this volatility does not equate to risk when approached with patience, conviction, and thorough independent research. Active stock picking is crucial to identifying potential multi-baggers and safeguarding against wealth destruction.

By transforming volatility into opportunity, investors can unlock the hidden potential within this segment. For instance, small caps have delivered higher alpha returns, PAT growth, and consistent CAGR of 25-30 per cent when selecting the right companies, outpacing the performance of larger caps​​.

Market volatility often presents dip-buying opportunities, allowing investors to enter solid businesses at more attractive prices. In March 2024, the 17 per cent decline in the Nifty Microcap 250 Index fueled concerns about overvaluation, but this correction can be seen as a chance to acquire high-quality stocks at better prices.

By leveraging these opportunities, investors can ride these businesses to become multibaggers. This perspective transforms the market from a foe into a friend, enabling long-term wealth creation through strategic investments.

Conclusion: Beyond the Headlines Lies Opportunity

While headline numbers are important, they do tend to obscure the true potential within the microcap segment. Aggregate data fails to capture the dynamic growth and value opportunities that granular analysis can uncover. By focusing on specific market segments and employing a rigorous selection process, investors can navigate market volatility and capitalize on the overlooked gems in the microcap universe, paving the way for substantial long-term gains.

For those interested in exploring the exciting potential of the microcap space, detailed sectoral analysis and a bottom-up stock-picking approach are crucial. This methodology not only mitigates risks but also uncovers high-quality investments that outperform broader market averages. Embracing this approach allows investors to navigate market volatility and capitalize on the overlooked gems in the microcap universe, paving the way for substantial long-term gains.

Disclaimer: The opinions expressed above are personal and may not reflect the views of DSIJ.