Small-Caps: Big Prices, Questionable Value

Dr. Ruzbeh Bodhanwala and Dr. Shernaz Bodhanwala, faculty at FLAME University, Pune, undertake an analysis and suggest that if the valuations are overstretched in Small-Cap stocks, it is best to diversify and move to Large-Cap stocks, which are highly liquid and relatively undervalued 

With Indian equity benchmarks, Nifty and Sensex, making new lifetime highs, it’s crucial to pay attention to the valuation metrics. In this study, we aim to understand the extent of overvaluation or undervaluation in the Indian equity market. We are using price-to-earnings (PE) ratio and price-to-book (PB) ratio as the valuation multiples and examining the gaps between large-caps, Mid-Caps and small-caps. We have selected the top 500 stocks based on their market capitalisation and classified the top 100 as large-cap stocks, followed by the next 150 stocks as mid-cap stocks, and the remaining as small-cap stocks. This analysis will help us identify potential risks in the market.

The mean reversion theory in finance is a pivotal concept. It teaches us that asset prices tend to revert to their long-term mean values. The further the deviation from the mean, the higher is the likelihood of a correction towards the mean. However, there can be exceptions, and stocks can persist in overvalued territory for an extended period, either due to sector tailwinds, the company’s performance relative to its peers, or sheer euphoria. American economist Alan Greenspan famously termed this as “irrational exuberance”. The problem arises when many stocks are trading significantly above their mean values and their fundamentals do not support the valuations.

This could strongly indicate a significant correction. Whenever corrections occur, they are more severe in small-cap stocks than large-cap stocks, primarily due to insufficient liquidity. As of June 27, 2024, the average market capitalisation of large-cap stocks was ₹2.8 lakh crore, mid-cap was ₹54,000 crore and small-cap was ₹15,000 crore. As the saying goes, a picture is worth a thousand words. In line with this, we have plotted the PE multiples of 2014 versus 2024 for large-cap, mid-cap and small-cap stocks, using a box plot. This visual representation provides a clear and concise comparison of the two years.

As can be seen, the PE multiples in 2024 in small-cap stocks are far too stretched compared to what they were in 2014 and compared to large-cap stocks. The median PE ratio of the small-cap category is 44 compared to 14.4 in 2014. The median PE for large-cap and mid-cap stocks in 2024 (cf. 2014) is 33.3 (18.7) and 50.2 (19.0), respectively. Let’s see if there is a similar story when we plot the PB ratio for the same stocks.

The PB ratio indicates the relationship between market capitalisation and the book value of the equity and conveys the same story as expressed by the PE ratio. The PB ratio of many small-cap companies is much higher than that of 2014 data and that of large-cap stocks. The median PB ratio of the small-cap category stood at 5.3 in 2024 compared to 1.5 in 2014. One justifiable rationale for the overstretched valuation of smallcaps could be a high return on equity (ROE) or high sales growth. So, technically speaking, if the small-cap companies have high ROE, then this would justify their high valuation. Alternatively, we can explain the overvaluation if these companies have high growth rate (proxy sales growth).

Whenever corrections occur, they are more severe in small-cap stocks than large-cap stocks, primarily due to insufficient liquidity. As of June 27, 2024, the average market capitalisation of large-cap stocks was `2.8 lakh crore, mid-cap was `54,000 crore and small-cap was `15,000 crore.

In 2024, the median ROE for large-cap, mid-cap and small-cap categories were 16.9, 16.4, and 15.7, respectively. For the same period, the median year-on-year revenue growth for large-cap, mid-cap and small-cap categories were 13.6, 12.9, and 10.5, respectively. If returns and growth are not the differentiators, the question arises about what drives the prices of the small-cap stocks. One reason could be an increase in the systematic investment plan (SIP) flows and direct investments by noninstitutional investors favouring the small-caps. We don’t deny that valuations may be justified in some pockets of small-cap stocks, but it would be like looking for a needle in a haystack. An investor should constantly remember that capital protection is the key to survival in the stock markets. If valuations are overstretched in small-cap stocks, it is best to diversify and move to large-cap stocks, which are highly liquid and relatively undervalued, or consult your investment advisors, who will guide you in finding the right small-cap stocks based on your risk profile. This is a prudent approach to investing. Retail investors should not only look at returns but also consider the risk of capital when investing.