Picking Nickels in Front of a Steamroller

This Article was originally published in The Global Analyst

Should one invest in penny stocks, also called as microcaps? Why not, if it has generated the best returns compared to say Nifty 50. The Nifty 250 microcap index is up by 73% YTD compared to 28% for Nifty 50. After all blue chips today have started off as penny stocks! This probably is the logic why investors go after these penny stocks. They also give you the allure of being cheap (mostly quoted under Rs.10) and hence there is perception that “there is nothing much to lose but windfall to gain”.

A closer examination however reveals a different story.

The attractiveness of an asset class should be examined from various factors as outlined in the table. The main stock exchange i.e., National Stock Exchange (NSE) has seen robust increase in the number of stocks listed over the period. From approximately 900 stocks back in 2006, the universe of stocks has expanded to more than 1,600 stocks now offering plenty of scope for stock picking. However, the largest of them is grouped under Nifty 50 (comprising the top 50 stocks) and Nifty 100 (comprising the top 100 stocks) representing large cap stocks. The next 250 stocks are grouped under Nifty 150, labelled as micro cap stocks. The next layer of 250 stocks are grouped as Nifty 250 small cap stocks. The Nifty 250 micro-cap index represents stocks that are ever smaller than small cap stocks and this is our focus in this article. A review of statistics reveal the sharp contrast that one should observe before deciding to jump in this opportunity. Let us examine the attributes for a better appreciation of the problem.

Size: Penny stocks or micro caps represent the lowest end of the spectrum in terms of size. Size is usually measured in terms of market capitalization. While the Nifty 50 market cap (free float) is over USD 1 trillion, the micro-cap market capitalization is just USD 31 billion, hardly 3%. The average free-float market cap for Nifty 50 is USD 42 billion while that of Micro caps is only USD 125 million (0.3%). A better measure would be median market cap which stands at USD 11.5 billion for Nifty 50 while that of Nifty micro cap index is just USD 103 million (0.9%). The universe of micro caps is just too small and this opens up other problems as well.

Liquidity: The most important limitation of the small size of penny stocks is directly reflected in the liquidity as measured by Average Daily Traded Value (ADTV). The ADTV of Nifty 50 is about USD 61 billion while that of Micro caps is just USD 1 billon. The downside of this extremely small liquidity is the higher bid-ask spread, essentially a measure to see the difference between bid price (price to buy) and ask price (price to sell). The higher bid-ask spread pushes up the cost of acquisition for micro caps.

Research Coverage: Large caps and to an extent mid-caps enjoy some sort of research coverage by analysts (both buy-side and sell-side). While research opinions (especially sell-side brokerage reports) cannot be completely trusted, at least there is someone ready to provide some opinion about a company analyzing the future potential of the business in which the stock is involved. Absence of research reports will mean extensive due diligence on micro-cap stocks which can again be costly.

Corporate Governance: This is the biggest hurdle and can come in many forms. To start with, high promoter holdings in micro caps can open up opportunities for coordinated price manipulation with a motive to “pump and dump” (also called as circular trading). Weak corporate governance can also encourage insider trading where people with inside knowledge can participate in price manipulation process. Corporate governance is a qualitative parameter that includes the board’s strength, ability to communicate proactively and following ethical practice with stakeholders including tax payments. Micro cap companies normally score weakly on all these parameters.

Performance: As noted in the beginning, micro-cap performance was stellar compared to Nifty 50 during the current year. In a bull market (like the one now), almost all stocks (good, bad and ugly) tend to move up in price. However, the real test comes in bear markets where stock prices collapse and may experience serious drawdowns (measured as the extent of fall from peak to trough). The maximum drawdown for Nifty 50 during the last five years is 38% while that of micro caps is nearly 70%. In other words, investors that can stomach a loss of 70% on their investments can qualify to indulge in these investments.

Risk: The performance of indices should be looked at from a risk-adjusted perspective. Micro caps’ better performance is because they take more risk than other indices. The standard deviation of Micro cap index is close to 22 compared to 18 for Nifty 50. Standard deviation can also be used to measure Sharpe ratio (a measure to gauge risk-adjusted performance). The Sharpe ratio of micro caps is 0.4 compared to 0.56 for Nifty 50.

Index Diversification: To be fair, micro caps score better in terms of sector diversification compared to the broader Nifty 50. Micro caps are overweight in sectors like industrial manufacturing, power and consumer goods while it is underweight in financial services and information technology. Also the top 10 weight in Nifty 50 is about 40% compared to 14% for Microcaps.

Survivorship Bias: This is often ignored risk in analysis. This measures how long a company stays in the index. Frequently companies are churned out of index for various reasons including financial performance and liquidity. Also mergers and acquisitions can lead to elimination of a stock from the index. The number of stocks that move out of Nifty 50 is lower compared to Micro caps. When adjusted for this survivorship, the actual performance of the index can be far lower than what is depicted in analysis.

Mind the risk, before you jump the gun!

In summary, investing in penny stocks is like picking nickels in front of a moving steam roller. The risk of getting run down by the steam roller is far higher than the value of nickels one pick up. It is enticing to note that all large caps today started off as micro caps, which is an observation in hindsight or after the fact.

Finding the next Infosys or Bajaj Finance is more an exercise in hope laden with huge risks. While institutional investors can afford to take that risk as they can commit resources to due diligence, the same cannot be said about individual investors. If retail investors still want to take the bet of penny stocks, they are advised either to invest a small portion in the micro-cap index (which at least diversifies the risk) through the ETF route or in case where they are keen on stock picking, they should devote considerable time and energy in researching the stock before deciding to invest.

Happy Investing!

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