After exhausting their investment option in mid and small-cap stocks, equity mutual funds now plan to invest in micro-cap stocks. Recently, Motilal Oswal Mutual Fund launched the industry’s first dedicated micro-cap fund. Analysts expect more such launches by other fund houses in future.
Broadly speaking, micro-caps are stocks and companies that are not part of the BSE 500 and Nifty 500 indices. But for investment purposes, the fund managers are likely to stick to the 250 biggest companies beyond the BSE 500 index.
The micro-cap stocks currently account for less than 5 percent of the combined market capitalisation of all listed companies in the country.
One of the reasons for their low valuation is little or no investment by mutual funds and foreign portfolio investors in these companies.
This creates the possibility of a valuation re-rating in this space as more fund managers start investing in them and more micro-cap funds are launched. Recall that until a decade back, the mutual fund industry largely invested in large-cap stocks and then they began to nibble into mid-cap stocks followed by small-cap stocks.
Now the mid and small-cap fund category is as big, if not bigger, than the large-cap segment of the MF industry.
This has resulted in big valuation re-rating of mid and small-caps. While in the past, mid and small stocks used to trade at a discount to large-cap stocks now most often mid and small-cap stocks have higher price-to-earnings and price-to-book value ratios compared to large-cap stocks.
We expect a similar valuation explosion in the micro-cap stocks as they get popular among mutual fund managers.
Given this, it is the right time to accumulate quality micro-cap stocks that can attract investment from mutual funds, thanks to their growth potential and strong financial ratios.
For example, micro-cap stocks are currently trading at a price-to-earnings multiple of around 17X, nearly 25 percent lower than BSE Sensex companies’ current P/E of around 23.5X. Similarly, micro stocks' price-to-book value ratio is around 2X currently, nearly 40 percent lower than Sensex companies' average P/B ratio of 3.33X. This creates a big valuation re-rating opportunity in the segment and this could translate into large returns for early bird investors.
We have put together five micro-cap stocks that have the potential to attract interest from mutual fund investors that could rally in their stock price.
How did we select these stocks?
Our universe is based on the nearly 600 stocks that are part of the BSE Mid and Small Cap index but are not part of the BSE 500 index. These stocks were then analysed on the earnings growth, balance sheet leverage, return on equity in the last two years and their current valuation ratio.
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We then selected the top five stocks that offer the best combination of faster growth in revenues, EBITDA, net profit and dividend, sufficiently high return on equity, lower balance sheet leverage and lower price-to-earnings and price-to-book value ratios.
Here are the best five in our league table:
1. West Coast Paper, one of the country's top paper producers, is on the top of the list. The company has more than doubled its revenues and profits in the last two years but it is trading at a P/E and a P/B ratio of 3.6X and 1.3X respectively. Its three-year average return on equity at 18.5 percent is also nearly 400 basis points higher than Sensex companies' average RoE currently.
2. The automotive component maker Uniparts India is next on our list. The company’s earnings have almost doubled in the last two years and it has reported a three-year average RoE of 22 percent. But its valuation is quite low with a P/E of 12.5X and price to book value ratio of 3X.
3. The chemical manufacturer Sree Rayalaseema H-Strength Hypo Ltd is next on our list with a three-year average RoE of 18.1 percent. Its valuation is also on the lower side with a P/E and P/B ratio of 7X and 1.4X respectively. The company’s net sales and profits are up by nearly 70 percent in the last two years.
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4. The public sector crude oil refiner Chennai Petroleum Corporation (CPCL) is next on our list. It’s one of the cheapest stocks in the space with a P/E and P/B ratio of 3X and 0.9X respectively. It has a dividend yield of close to 7 percent based on its dividend payout for FY23. Its revenues and profits have more than tripled in the last two years and the company has deleveraged its balance sheet.
5. The textile manufacturer Siyaram Silk Mills is the last stock in our list with three-year average RoE of 15.2 percent and a relatively low P/E multiple of 10.2X currently. Its P/B ratio is also low at 2.3X. The company’s revenues have doubled in the last two years while its operating profit is up nearly 5X from a low base. The company has also deleveraged its balance sheet during the period and it could allow it to grow faster.
(Disclaimer: This article is for information purpose only. Readers are advised to consult a certified financial advisor before making investment in any of the funds or securities mentioned above.)
(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist).