Have you ever pondered over why is it hard to find hidden gems or multi-baggers when they are small? Because it is like mining for diamonds. You need to sift through a lot of dirt before you get one. And even if you find one, the diamond will be unpolished or rough.

The Microcap Diamonds

Investing in micro-cap companies is also similar to mining diamonds. You need to sift through a lot of data before you can find diamonds. But then, when a company is small & in its growth stage, it is hard to find enough data from public reports, as they are not elaborate. How do people do it anyway? What is the magic behind this?

Well, there is no magic. One way to solve this is to invest a lot of money & interview the management directly. But companies are generally busy growing & don’t have the bandwidth to engage with everyone – as such, if you are a fund manager or an extremely rich investor, you can usually get direct access to these small companies. But what about retail investors who want to become wealthy by investing in multi-baggers? Smaller investors are often excluded.

We at Lotusdew consider this as a financial inclusion issue and are working hard to make financial inclusion a reality for investors. To an extent, we want to democratize venture capital like pay-offs using micro-cap companies.

Also, access is not the only problem here. One of the other biggest challenges of investing in micro-cap companies is that they don’t have detailed reporting. The investors have to make do with the available quality of data.

Can you trust what you see given the way things have been manipulated by operators in the market? Some of the alleged examples where this might have happened are Manpasand Beverages, Vakrangee, Dewan Housing Finance Limited, just to name a few.

We think it is very difficult to solve this asymmetry of information – the management always knows more than the investor. We decided to turn the problem on its head, realizing the solution lies in the problem itself.

Insiders may be knowledgable – but they can’t make this knowledge public. As such, we need to find public indicators of unobservable facts. Students of finance will find that it is similar to hidden Markov models often used in machine learning. We have already worked on such an approach.

The idea behind the Lotusdew smallcase

Our approach is different from using traditional fundamental or technical price data to screen companies. We instead rely on adjacent indicators. For example, we all know that reputation is a public asset. The public lends it to you – and takes it away if you don’t pay the dues.  Also, reputation is hard-earned but can be lost in a blink. Consequently, reputation is one of the most expensive assets that people tend to lend.

The Lotusdew smallcase has been developed on this idea. We use our proprietary database to look exactly for people who have lent their reputation to smaller companies by agreeing to be their board members. It’s a bit like a VC fund that invests in startups and usually also takes a seat on their board.

Lotusdew smallcase Methodology

Our edge here is to use our proprietary database to track the background, education, work experience, etc. of board members of listed companies. Then, we see which of these credible board members are also on the Board of Directors of other small companies.

It is well known that insiders have the most information about the affairs of the company. So, these credible people who are board members, are likely to make a sound judgment on prospects if they want to remain a board member and see it grow.

The following people are on the Board of Directors of at least one company included in the Lotusdew smallcase:

• Mr. Kamalesh Shivji Vikamsey, Audit Member with the United Nations Development Program (UNDP)
• Mr. Padam Kumar Khaitan (founder of Khaitan Law Firm)
• Mrs. Ranjana Kumar, ex-Chief Vigilance Commissioner & also sits on the board of Tata Global Beverages

Using this as a screen to shortlist companies, we further do a selection based on the quality of their balance sheet and reported earnings. We then construct a basket of stocks that is representative of a broad Indian economy. That way we don’t miss out on any sector performance.

Constituents & Ideal Investors

To help you better understand, let’s take the example of one of the stocks we were looking at in 2019 was Aavas Financiers Ltd.

Ms. Soumya Rajan, the founder of WaterField advisors, was recently appointed on the board of Aavas Financiers.

Ms. Rajan has been an investor & has strong relations with many UHNIs. She also has a stellar reputation, a deep understanding of investments, and sits on the board of few foundations.

Our market surveillance picked this up, we tracked and researched this company since her joining. We noticed the company was visited by investment bankers like Goldman Sachs in Jaipur, and also had investor meets. They seem like they’re working on growing their market share – even as one of their competitors, Altico Capital, recently defaulted. While we’re still digging deeper into this stock, we are quite excited about the story.

Given the nature of this strategy, this is a volatile & high-risk investment. We recommend this as a satellite allocation within the broader portfolio (learn more about Core-Satellite Investing here). It’s suitable for those wanting to create wealth with a long-term view.

This smallcase might also appeal to those looking for a differentiated strategy that isn’t available via mutual funds. 

If you are looking to invest in such a differentiated and rewarding strategy focused on micro-cap companies that have the potential to grow into multi-baggers, consider investing in the Lotusdew smallcase.