Microcap shares are the last profitable option available at comparatively cheaper valuation in the ongoing bull market in India, even as low liquidity in such stocks continues to be a key risk, said a report by ICICI Securities. Wonderla Holidays, Somany Ceramics, Greenpanel, Sansera Engineering, ISGEC and Fusion Micro Finance, are some of the top micro cap stock picks from ICICI Securities’ coverage. According to the report, the microcaps, compared to small, mid, and large caps, have a lower valuation with a trailing earnings yield of 6% (trailing P/E of 16x-17x), excluding loss pools. In contrast, large caps have a trailing earnings yield of 4% (trailing P/E of 24x).
Risk tolerance towards microcaps has room for improvement, suggest past trends
The report said that if the current bull market persists, there is scope for risk tolerance towards microcaps to expand. Past trends have shown that the earnings yield spread between microcaps and large caps has narrowed to almost zero, compared to the current spread of 150-200 basis points. “Assuming that the current bull market continues, driven by a broad-based investment cycle, the probability of a repeat of past behavior cannot be ruled out,”said the report.
Large loss pools may have distorted microcap stocks valuations
The report however, said that headline valuation of the microcap index is distorted and appears optically high as significant loss pools exist within the microcaps. “Despite the total free float profit of the NIFTY Microcap 250 index amounting to Rs 112 billion, it is alarming that the pool currently stands at Rs 90 billion, which amounts to 80% of the free float profit. This creates the distortion in the headline valuation of the microcap index when the significant losses are included in the denominator while calculating the aggregate P/E ratio,” said the report.
Quality microcap stock up for grabs
However, the wider availability of stocks with minimum quality standards (RoE > 10%) available at a cheap price, adds to the advantages of microcaps. “Currently, in the microcap universe (market cap rank from 501 to 1,000) there are around 80 stocks with RoE > 10% and earnings yield > 10-year government bond yield which allows screening within a wider universe of stocks available at cheap valuations with minimum quality standards,”said the report.
The report further said that the microcaps pose liquidity risks due to a majority of stocks having an average daily turnover below Rs 100 million and their nature of being predominantly cyclical. Also, during an economic downturn characterized by a bear market, microcaps face the dual challenges of the “beta” factor working against them and the liquidity risk, leading to significant corrections.