Which Cap Should You Buy Now?

As the global scenario changes every now and then with persistent geopolitical conflicts and inflation worries, investors may be feeling short-changed at the current moment on account of the dips in the equity markets. At such a time, should you be looking at Large-Cap equities more favourably than Mid-Caps and Small-Caps due to their ability to withstand volatility? The article takes into stock the current scenario and the red flags that are dominating the markets, and provides a few suggestions for the way forward [EasyDNNnews:PaidContentStart]

The past few months have been particularly challenging for Indian equity investors. They have found themselves navigating a market environment vastly different from the one they had grown accustomed to in recent years. Previously, the market followed a pattern of shallow declines and rapid recoveries, frequently pushing the indices to new highs. This consistent upward trajectory had enabled major equity indices to deliver double-digit returns over the past year and in a way made many investors complacent of inherent risk associated with equity investment. 

The current market downturn appears distinct from recent trends and serves as a reminder that equities are not akin to fixed deposits. To analyse this, we examined the Nifty 500 index, which represents a mix of large-cap, mid-cap and small-cap stocks. Over the past 15 months, the index has experienced three significant declines: 

1. September-October 2023: The index fell by about 7 per cent but rebounded within a month.
2. Post-Election Results in June 2024: A steep 10 per cent drop occurred over two days, followed by a quick recovery within a week.
3. August 2024: The markets saw another sharp decline, spurred by fears of a U.S. recession and concerns that the U.S. Federal Reserve might delay rate cuts, worsening the situation. 

Additionally, the Bank of Japan’s (BoJ) rate hike unsettled investors amid reports of the unwinding of the Yen carry trade. Geopolitical tensions further added to the global market’s anxiety. Yet, the markets bounced back swiftly. However, the current decline, which began after the peak on September 26, remains unresolved. Unlike previous corrections, we have yet to reclaim those highs. Interestingly, many global markets are performing well, with several hitting all-time highs. While our equity indices showed signs of recovery in early December, they still remain a few percentage points shy of their all-time highs. 

Disappointing Results
One of the key reasons our markets struggled over the past quarter was the weaker-than-expected earnings reported by India Inc. for consecutive quarters. In the September 2024 quarter (Q2FY25), India Inc. continued to face muted revenue growth, following a lacklustre performance in the first quarter of the fiscal year. Margins and profits also declined, with the challenges being more pronounced for non-financial companies. In contrast, firms in the banking, financial services and insurance (BFSI) sector significantly outperformed the broader corporate sector. 

The following analysis of Q2FY25 earnings for Nifty 500 companies, categorised into financial and non-financial segments, provides deeper insights into their performance. 

The chart highlights the year-on-year (YoY) performance differences across key financial metrics for overall, nonfinancial and financial companies. Financials significantly outperformed both overall and non-financials in revenue growth, recording a robust 13.5 per cent. Similarly, financials exhibited strong growth in EBITDA/pre-provisioning profits at 19.8 per cent, while non-financials declined substantially by –6.5 per cent, pulling the overall figure into negative territory at –0.6 per cent. In terms of PBT, financials excelled with a 16.3 per cent YoY increase, whereas non-financials showed a pronounced decline of –11.8 per cent. 

The adjusted PAT further emphasised financials’ leadership at 16.9 per cent growth, in contrast to a –6.0 per cent decline for non-financials, limiting overall growth to 2.3 per cent. Finally, financials showed resilience in the EBITDA margin, with a relatively smaller impact (-80 bps) compared to the sharp decline in non-financials (-200 bps), which adversely affected the overall margin. 

The street was already expecting a dismal quarterly number but it came even below it. This wave of earnings’ downgrades has contributed to a broader market correction. The total profit of 1,500 BSE listed companies saw a drop by 0.6 per cent YoY — the first cumulative earnings’ decline in eight quarters. For comparison, these firms posted a robust 47.4 per cent YoY increase in net profit in Q2FY24. 

In the quarter ending September 2024 (Q FY25), Indian corporate earnings exhibited signs of deceleration, reflecting broader economic challenges. The following graph showing variation in profit after tax clearly highlights that. This is from one of the brokerage firms’ analysis of companies’ PAT under their coverage universe. 

On a YoY basis, metals and oil and large-cap metals and oil outperformed and their numbers were better than the estimate. However, others, mid-cap companies (88) and small-cap companies (105) fell short of expectations. The quarter-overquarter (QoQ) trends highlighted positive growth in large-cap ex metals and oil and Sensex 30, whereas smaller-cap segments, including mid-cap and small-cap, experienced significant declines. Major indices like Nifty 50 and Sensex 30 performed in line with the expectations, showcasing stability and minor deviations. However, the mid-cap and small-cap segments significantly underperformed, both YoY and QoQ, reflecting challenges in these categories. 

It’s not only that the numbers were bad; even consensus EPS and target price revisions post-results were not very encouraging. It was found that 66 per cent of the companies experienced EPS downgrades for FY25, with 40 per cent seeing cuts exceeding 3 per cent, 29 per cent over 5 per cent, and 18 per cent more than 10 per cent. Additionally, 45 per cent of the companies faced reductions in target prices post the QFY25 results. The mid-cap and small-cap firms were particularly affected with 17 per cent of the mid-caps and 23 per cent of the small-caps seeing EPS cuts above 10 per cent, compared to only 10 per cent for the large-caps. 

The weak earnings have also dampened the sentiment of overseas investors, who have turned increasingly bearish on the Indian market. Foreign portfolio investors (FPIs) have been relentlessly pulling out funds in recent months, signalling declining confidence in the country’s economic growth prospects. This decline is also reflected in the latest release of quarterly GDP numbers. India’s GDP growth slowed to 5.4 per cent in the July-September quarter, down from 7.6 per cent in the same period the previous year. Factors such as weak urban consumption, elevated food prices and subdued government spending have contributed to this deceleration. 

Recent FIIs Trend in India
The strong FII inflows into Indian equities, which followed the U.S. Federal Reserve’s aggressive 50 basis point rate cut in September, quickly reversed in the subsequent month. In October, FPIs remained net sellers in every trading session, pulling out a record `1.14 lakh crore worth of Indian stocks through the exchanges. As FPIs sold Indian stocks relentlessly in October and November, both the Nifty 50 and Sensex dropped over 8 per cent, recording their worst monthly performance since March 2020 in October 2024. 

The following graph shows the monthly performance of Nifty 50 against the FII inflows. It clearly indicates that there is a direct correlation between FII inflows and Nifty 50 returns, with good statistical significance indicated by a p-value close to zero, reflecting strong statistical validity. 

Nonetheless, after two months of relentless selling, FIIs have turned net buyers in December, suggesting that the worst of the sell-off may be behind us for now. If this trend continues, FIIs are likely to invest in stocks where they perceive stronger growth potential and more attractive valuations. 

Valuation 
Let’s analyse the valuations of the large-cap segment represented by Nifty 50, the mid-cap segment represented by Nifty MidCap 150, and the small-cap segment represented by Nifty Small-Cap 250. To do this, we will focus on two key valuation metrics: price to earnings (PE) and price to book value (PBV). Both metrics will be calculated using trailing 12-month (TTM) data to provide a clear perspective on the current valuations. 

For the PE ratio, since consistent data for the small-cap and mid-cap indices is not available before 2021, our analysis will consider data from 2021 onwards. On the other hand, for the PBV ratio, we have a longer dataset starting from 2018, allowing us to draw more comprehensive historical insights. This approach ensures a balanced evaluation of where these segments currently stand in terms of valuation. 

Price to Earnings 
Nifty 50, India’s benchmark index, currently trades at a PE ratio of 22.52 times, which is close to its historical median of 22.46 times and slightly below its mean of 23.15 times. This indicates that the index is fairly valued or even slightly undervalued relative to its historical levels. Additionally, its current PE is closer to the 25th percentile (21.43) than the 75th percentile (23.58), suggesting potential upside with limited downside risk. 

On the other hand, the mid-cap and small-cap indices show clear signs of overvaluation. The mid-cap index is trading at a PE of 42.94 times, which is significantly above its mean of 30.35 times and close to its historical maximum of 45.25 times. Similarly, the small-cap index, with a current PE of 34.91 times, is well above its mean of 26.74 times and the 75th percentile of 30.67 times, approaching its historical high of 47.15 times. This sharp divergence from historical averages highlights a potential risk of correction. 

While these segments may still attract growth-oriented investors due to their potential for higher returns, their elevated valuations suggest caution, as they are priced for perfection and could be vulnerable to adverse market developments. For conservative investors or those looking for stability, Nifty 50 stands out as an appealing choice in the current market conditions. 

Price to Book Value
Going ahead, we also analysed the historical PBV of these three indices. Our analysis of the historical PBV ratios for the three indices indicates that the Nifty 50 (large-cap) segment offers the most attractive valuation for investors. With a mean PBV of 3.79 and a median of 3.73, Nifty 50 is currently trading near its historical average, suggesting fair valuation levels and relative safety. 

In comparison, the Nifty Mid-Cap 150 and Nifty Small-Cap 250 indices, while offering greater growth potential, come with higher risks. The mid-cap index, with a PBV range of 1.89 to 5.91, is trading two standard deviations above its long-term average, indicating overvaluation. 

Similarly, the small-cap index, despite a recent correction, has the lowest mean PBV of 2.76 but the highest standard deviation of 0.87, reflecting significant volatility. It is currently trading one standard deviation above its long-term average. For investors who prioritise stability and fair valuations, Nifty 50 remains the most compelling option compared to the riskier mid-cap and small-cap segments. A higher standard deviation of 0.77 indicates more fluctuation in valuations, making it suitable for investors willing to take moderate risks. 

The Nifty 50 (large-cap) stands out as the most attractive segment based on its proximity to the median and safety from extreme overvaluation (two standard deviations above the mean). Mid-cap and small-cap indices, while offering potential growth, are more volatile and closer to their risk thresholds, making them less favourable for risk-averse investors. 

Rolling Returns
To gauge the three-year annualised performance of these indices and understand where they are currently relative to their historical averages, we can analyse their past performance data. This will provide insights into their potential future performance and help investors make informed decisions. 

The chart above illustrates the three-year annualised return differences between the following indices:
1. Mid-Cap versus Large-Cap (Orange Line): The performance gap between the Nifty Mid-Cap 150 and Nifty 50 indices.
2. Small-Cap versus Large-Cap (Purple Line): The performance gap between the Nifty Small-Cap 250 and Nifty 50 indices. 

"Large caps for stability, mid caps for growth, and small caps for dreams – your portfolio is the canvas, choose the right blend to paint your future." 

The baseline at zero represents the point where the mid-cap or small-cap returns match the large-cap returns. Positive values show outperformance over the large-caps, while negative values indicate underperformance. A comparison of rolling three-year returns reveals a clear trend: mid-cap and small-cap stocks tend to outperform large-caps during bullish periods but come with higher volatility. This volatility is reflected in the wider dispersion, as shown by the ±1 and ±2 standard deviation bands. In contrast, large-cap stocks, represented by Nifty 50, offer more stable returns with smaller deviations around the baseline. 

This stability makes large-cap stocks a safer choice during market uncertainty or economic slowdowns. As global and domestic markets face challenges due to geopolitical risks or economic slowdown, large-caps are likely to remain resilient due to their strong financials and market dominance. However, during robust economic recoveries, mid-caps and small-caps may capture growth more effectively. Therefore, a balanced,diversified approach to asset allocation is prudent. Moreover, as annualised returns revert to mean we believe large-caps are likely to perform better than their mid and smaller counterparts. 

Outlook
Despite the current downturn, we anticipate a recovery in the latter half of FY25, supported by higher government spending, a strong festive season, and improved rural demand. However, persistent inflation and global economic uncertainties could continue to challenge corporate earnings’ growth. Based on current earnings and analysts’ future estimates, large-cap stocks are better positioned to withstand this volatility. With foreign institutional investors (FIIs) returning to the Indian markets, large-cap stocks are likely to recover more effectively than mid-caps or small-caps. Therefore, for conservative investors with a shorter investment horizon, large-caps appear to be the more favourable choice. 
 

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