A deep dive into the future of small-cap investing

This article is authored by Pawan Bharaddia, Co-Founder of Equitree Capital

The markets have been abuzz with various media reports suggesting that Large-Cap companies are better poised in terms of valuations now than the small caps, primarily because of the run-up in Small-Cap companies.

The consensus seems to be that Nifty currently trades at 12-month forward P/E of ~ 19.6x which is below its 10-year average of 20.2x and marginally higher than its 5-year average of 19.1x. Likewise, Nifty Small Cap 250 index seems to be trading at 21.8x currently which is higher than its 5-year average of 18x.

In our opinion, the 5-year average may not be the right indicator of the valuation matrix to begin with as it includes the black swan event of Covid making the averages a bit erratic. Further, while one looks at the benchmark index as a lighthouse to get a sense of valuations, however, that itself has limitations due to the smaller representation of companies which could again present very erratic outcomes.

A nuanced analysis of valuations for a broad range of companies based on their market cap over a 10-year period is a better indicator of where we stand vis-à-vis current valuations.

The result is summarized here:

It is interesting to note that the larger Small-Caps / Mid-Caps / Large-Caps (market cap with more than Rs 20,000 crore) are trading at 20-30 per cent premium to their 10-year averages! The Small Caps in the market cap range of Rs 200-5,000 crore is trading at a mere 7 per cent premium to its 10-year average PE multiple!! It is this genre where one can still continue to find enough and more opportunities.

It's worth highlighting that at Equitree, the median valuation of our portfolio is 14x FY25.

We have seen massive liquidity chasing stocks in certain pockets like SME, Larger small cap and mid-caps leading to exuberance in these pockets.  Needless to say, this excess liquidity has gone into chasing the same stocks in which most of these funds / PMSs are already invested with little new additions. It is these stocks again where one has seen significant re-rating of companies driving the valuations to levels where future gains will be curtailed.

Recency bias seems to be setting in for outperformance of Small Caps:

This year, the Small Cap Index has risen by 62 per cent, significantly outshining the Nifty's 20 per cent gain. However, it's worth noting that such short-term gains often overshadow longer-term performance.

A closer look reveals that 57 per cent of Small Caps’ gains of the last three years came about in the previous year, and 94 per cent of the six-year returns accumulated in the last year alone, amounting to a modest 5-6 per cent annual return in the preceding five years.

Even with this year’s stellar performance, Small Caps have not surpassed the six-year returns of Large Caps, as illustrated below.

We believe that this underperformance observed cannot be rectified by a mere 1-2 years of outperforming trends. Despite volatility, we foresee the Small Caps outperforming in the next 2-3 years as part of a mean reversion over a decade, ultimately leading to their long-term outperformance.

Correction is inevitable – one MUST use the opportunity to build up a long-term portfolio

2024 is starting on the backdrop of good returns. After these kinds of returns, it wouldn’t be out of context for the market to take a breather before it moves ahead, and this may call for a time correction and/or an absolute correction. 

We believe that a 5-7 per cent correction in the headline indices is not out of context and with that small caps may also see a drawdown of around 20-25 per cent in the worst scenario. We believe that if such an opportunity arises, one should be ready to lap it up and build a portfolio of high-quality businesses to create wealth from a mid to long-term perspective.

Disclaimer: The opinions expressed above are personal and may not reflect the views of DSIJ.