Cover Story: How to be a micro cap master

5000-1 - Those were the odds of Leicester City Football Club winning the top flight of English football in the 2014-15 season. The club had narrowly avoided relegation the previous year. In a bid to stabilise, Claudio Ranieri, recently dismissed as Greece's national coach, was appointed manager. His recent firing hardly boosted fans' confidence. Yet, defying every expectation, the club clinched the Premier League trophy. They outperformed giants like Manchester City, a team whose budget rivals that of a small nation's GDP. In the last 12 months, we have seen many such underdog stories in the market. Specifically, 926 small businesses, known as micro caps, eclipsed several market giants and doubled in value. This issue is all about micro caps, including the benefits and risks of investing in them. We also borrow the wisdom of Ian Cassel, a leading micro-cap investor, and provide a guide to analysing micro-cap stocks. Our goal is to help you identify Leicester-like stories unfolding in the market. But before we kick off, know this: micro-cap investing is a risky affair. While our framework can help you make wiser decisions, there are no risk-free roads to micro-cap success. Fortune favours the bold: Why investing in micro-cap stocks might be tempting In 1996, Arsenal Football Club was far from its glory days of the 1980s and in search of a new direction. Despite numerous high-profile candidates being in the mix, then-Vice Chairman David Dein made the bold choice of appointing Arsène Wenger, a Frenchman with no prior experience in English football. Critics were sceptical as no foreign manager had previously won the Premier League. The media's response was encapsulated in headlines like 'Arsène Who?' But Dein was firm that Wenger's revolutionary approach to football and fitness would lead them to success. So, he took a risk that few were willing to take, and the rest, as they say, was history. Wenger guided the club to three Premier League titles, including a historic unbeaten season, and revamped the club into a global powerhouse. The market, like the game of football, is also known to reward risk-takers. Micro caps, as the name suggests, are relatively small businesses and fraught with risks. But it offers fortunes to those who dare. For instance, micro caps that went on to become mid caps gave an average 10-year annualised return of 73.6 per cent, the highest among any category. To put that into perspective, an investment of Rs 1 lakh would compound to Rs 2.5 crore at this return rate! So, should you channel your inner David Dein and take a punt on these stocks? The answer to that depends on your risk appetite. We can, however, give you three reasons why micro caps entice even the wiser investors: Sky-high growth rates: You may have heard the last stretch is always the toughest. This applies to businesses, too. Matured businesses struggle to grow after reaching a certain scale, as few growth avenues remain unexplored. Micro caps, on the other hand, are budding businesses. The legroom for growth is immense, and hence, these stocks usually exhibit exponential growth. In the past five years, micro caps have secured a 17 per cent annualised operating profit growth, higher than both large and mid caps. Simplicity: Are you comfortable investing in a business you do not fully comprehend? Most are not. Conglomerates especially are infamous for leaving investors dizzy. Take Reliance Industries, for example. The conglomerate encompasses a staggering 255 companies. The sheer scale alone is enough to deter any attempt to analyse the company. Micro caps are the mirror opposite. They more often than not focus on a single business and sell fewer products, and thus, are relatively easy to decipher. The rewards of early discovery: Retail investors must spot promising businesses before the broader market to reap the highest return. In other market cap categories, the odds are against retail investors, as they have to compete with institutional investors. Micro caps, however, are a domain institutional investors seldom traverse. So, the playing field is fairer, and the return potential is higher. Fortunes lost in pursuit: Why investing in micro caps often lead to losses David Dein's gamble on Wenger underscores that going against the consensus has its rewards. However, consensus - whether in football, the financial markets or life, often harbours kernels of truth. And not every challenge to the status quo results in success. Consider the case of Bob Bradley, who in 2016 became the first American to manage a Premier League team, Swansea City. Echoing Wenger's early critics, pundits predicted Bradley's lack of Premier League experience would be his downfall. Unfortunately, unlike Wenger, Bradley's efforts to defy these expectations fell short, resulting in a tenure of just 85 days. In the financial world, a similar narrative unfolds. Micro caps are deemed risky because they are. For every tale of meteoric rise, there are numerous others of decline and loss.An analysis of historical data reveals a telling trend: a significant portion of micro-cap investments fail to yield positive returns. In our table titled 'Worrisome Micros', you can see that in every period, at least one-fourth of the companies have led their investors to losses. Does this mean micro-cap investing is a fools' gamble? No, but there are factors you should consider before venturing into micro caps. Here's some of them. Not all stand the test of time: Long-term growth requires time and resilience to navigate through competition and economic challenges. However, many microcaps lack the necessary resources and expertise to endure these obstacles. As a result, numerous micro caps struggle to sustain themselves beyond the initial growth stage, especially when faced with competition from larger corporations. Low liquidity: Unlike larger companies, micro caps have less visibility and trade infrequently. This results in fewer buyers and sellers, leading to volatile trading conditions; the six-month average trading volumes for large, mid, small and micro caps are 52, 19, 8 and 2 lakh, respectively. Prone to manipulation: Micro caps often receive negligible media coverage, making them an easy target for pump-and-dump schemes and other price manipulation hacks. Lack of information: Due to their inherent obscurity, micro caps lack readily available information, which can lead investors to make uninformed investment decisions. So, how should one proceed? You can say you are risk-averse and deem micro caps as a no-go

This article was originally published on April 01, 2024.