Investing in microcaps: Limit exposure to 5-10%, enter with 5-7-yr horizon

High volatility, low liquidity, and corporate governance are risks investors need to be prepared for

The Securities and Exchange Board of India (Sebi) Chairman Tuhin Kanta Pandey has cautioned mutual funds against investing heavily in microcap companies, citing liquidity constraints and volatility. Retail investors who invest directly in these stocks or indirectly through mutual funds need to be mindful of the associated risks.

 

What are microcaps? 

Sebi classifies companies into large-cap (1–100 by market capitalisation), mid-cap (101–250), and small-cap (251 and beyond). Microcaps are firms ranked beyond the top 500 by market capitalisation. The Nifty Microcap 250 Index covers those ranked 501–750. These are often small, under-researched businesses operating in niche areas.

 

Unlike penny stocks, defined mainly by low share prices (generally ₹₹10–20 per share or lower), microcaps can include genuine companies with growth potential.

 

High return potential 

Microcaps offer early-stage growth opportunities. “If the business model scales up, wealth creation can be significant as today’s microcaps become tomorrow’s midcaps. The big reward lies in spotting a growth story before the crowd does,” says Shrikant Chouhan, head of equity research, Kotak Securities.

 

“A successful new product, expansion into new markets, or a strategic partnership can lead to rapid growth and significant returns,” says Devarsh Vakil, head of Prime Research, HDFC Securities. 

 

Over the long run, microcaps have delivered strong performance. “The 15-year annualised return of the Nifty Microcap 250 Index is 18.99 per cent compared to 12.40 per cent for the Nifty 50,” says Varun N Joshi, smallcase manager and director, GoalFi.

 

Volatility, liquidity risks 

The stocks, however, carry considerable risks. “Trading volumes are usually very thin. Even a few lakh rupees worth of buying or selling can move the stock significantly,” says Chouhan. This makes it difficult for investors to enter or exit without impacting the price.

 

Vakil adds that these stocks are vulnerable to market fluctuations, economic changes, and company-specific news.

 

Microcap stocks are far more volatile than large-caps. “The Nifty Microcap 250 Index shows 21–24 per cent yearly volatility versus 13–17 per cent for the Nifty 50. In the 2020 pandemic, microcaps fell more than 40 per cent while large-caps fell around 25 per cent. In the 2008 crash, microcaps fell more than 70 per cent,” says Joshi.

 

Low float, concentrated holdings, and fragile business models add to risks. “Good ideas often fail to scale as promoter bandwidth, management depth, and access to capital become bottlenecks,” says Chouhan.

 

These stocks also carry governance-related concerns. Related-party transactions and questionable capital allocation are quite common.

 

Are they right for you? 

Investors need strong conviction and a high risk appetite. “They should be mentally prepared for portfolio drawdowns of 30 per cent or more and still stay committed to their convictions, provided underlying business fundamentals remain intact,” says Pawan Bharaddia, co-founder and chief investment officer (CIO), Equitree Capital. Sometimes, drawdowns can be as high as 50–70 per cent.

 

Microcaps should not form part of core holdings. “Unless one researches individual companies deeply, microcap exposure should be limited and diversified. Such stocks may be useful for aggressive portfolios, but should not be part of the core holdings,” says Umeshkumar Mehta, CIO, SAMCO Mutual Fund.

 

Microcaps are not passive buy-and-hold investments. “They require frequent monitoring. Approach microcaps like venture capital—many ideas will fail, some will stagnate, and a few will deliver 10x-plus returns,” says Mehta. 

 

Due diligence is critical 

Retail investors need to look out for significant red flags prior to investment. “These include accounting irregularities, poor liquidity (daily trading volume less than ₹₹5 crore), excessive promoter pledges, high frequency of management changes, and abnormal trading activity. Investors should also check debt levels, quality of cash flow, and reliance on a single customer or supplier,” says Joshi.

 

Pay special attention to corporate governance-related issues. “Watch out for resignation by the auditor, related-party dependencies, ballooning receivables, and lower promoter skin in the game,” says Mehta.

 

He specifies that the promoter’s shareholding should be above 40 per cent, and not more than 5 per cent should be pledged.

 

On financials, he suggests that the company’s profitability should have been consistent over the past three years, with a growth rate of 25 per cent or above under the same chief financial officer. Mehta also warns against going with a company that has been red-flagged by regulatory authorities.

 

Go for emerging small-caps, not illiquid microcaps. “Focus on stocks in the range of ₹5,000 crore and above market cap with improving fundamentals,” says Mehta. 

 

Bharaddia warns against investing in fashionable sectors without adequate knowledge, entering at stretched valuations, or going for companies that frequently issue equity (as it indicates limited capacity for cash generation). He adds that resignations by independent directors or CXOs are also warning signs.

 

Exposure to these stocks should be limited. “Investors should limit exposure to 5–10 per cent of the portfolio, and they should have an investment horizon of 5–7 years to weather volatility,” says Joshi.

 

The MF route 

One open-end passive option exists: Motilal Oswal Nifty Microcap 250 Index Fund. “Seasoned investors with high risk tolerance, surplus capital not required for necessary goals, and who can stay invested for 8–10 years can consider a measured allocation in their satellite portfolio to a microcap fund,” says Charu Pahuja, certified financial planner, group director, and chief operating officer, Wise Finserv.

 

She cautions that conservative savers, retirees, and those with near-term financial commitments should avoid a microcap fund.

 

Small-cap and thematic funds often hold microcaps in their portfolios. “Funds with a large exposure to microcaps will face risks like poor liquidity, governance concerns, and sharp price swings. If investors are unaware of this embedded risk, their portfolio may be more aggressive than intended,” says Pahuja.