Small-Caps: Book Profits or Remain Invested?

Our analysis of the performance of Small-Cap stocks indicates that while the broader markets are expected to rise, caution is advised regarding extreme valuations. Therefore, it is recommended to choose quality small-cap stocks based on thorough fundamental and technical research. The article highlights the reasons for doing so 

Over the past one year, the Indian equity market has experienced remarkable gain, particularly in small-cap stocks, which have delivered exceptional returns. There are more than 300 companies in the small-cap space that have witnessed their share price doubling over the past 12 months. A company like Waaree Renewable Technologies with market capitalisation of ₹24,000 crore has seen its share price soaring upward by 13.6 times since the start of FY24. Its price has increased from ₹158 on April 3 to ₹2,313 as of now. 

Another example is Transformers and Rectifiers (India) Ltd. that saw its share price increasing by 981 per cent in the same period. However, this ascent has not been without its challenges and we have witnessed hiccups in between. In September 2023, Kotak Institutional Securities raised concerns about ‘irrational exuberance’ among investors with regard to the broader market, leading to a significant drop in prices for small stocks along with Mid-Cap stocks. 

Before that, the Nifty Mid-Cap index had risen by 20 per cent and 32 per cent, while the Nifty Small-Cap index was up 23 per cent and 35 per cent in the three and six months ending August 2023, respectively. At the index level we saw the mid-cap and small-cap indices dropping by 3 per cent and 4 per cent, respectively, in a single day after this report. The graph below shows the movement of major Nifty equity indices since the start of April 2023. It clearly shows the ascent with two drops in between. 

Similarly, in March 2024, the small-cap and mid-cap stocks faced another setback. Regulatory statements warning of market froth, coupled with an Enforcement Directorate investigation into the Mahadev Online illegal betting app scam, contributed to a sharp decline in these categories of stocks. The small-cap index plummeted by over 5 per cent, marking its worst single-day fall since December 2022, while the mid-caps and micro-caps also experienced losses of around 4-6 per cent. This downturn contrasts with the global trade scenario, where the S & P 500 reached record highs. This was despite foreign institutional investors (FIIs) injecting USD 3 billion into Indian stocks that month. 

Now we are half past May 2024 and the small-cap index is trading at almost an all-time high, gaining as much as 77 per cent since April 2023. The last time we saw similar returns in small-caps was post the corona virus-triggered pandemic. So, the question is about what should be the course of action as regards small-cap stocks? The broader equity market has once again started to outperform the frontline indices after underperforming for two straight months, February and March. Would this be the right time to enter the small-cap segment? To get the answer you need, you should be clear about whether you are a small-cap investor or a long-term investor. 

Short-Term Investor
In case you are a short-term investor, you need to look at the current valuations of the small-cap index as well as companies you are zeroing in for investment. Looking at the index level, we believe that it warrants caution. On a 12-month forward basis, the Nifty Small-Cap index is trading above a standard deviation with respect to its long-term average. It is currently trading at 20 times against the long-term average of around 15 times. 

Even if we take the price-to-book value (PBV) ratio of Nifty Small-Cap 100, which has more reliable and long-term data, we see that even this valuation metric is trading much above its long-term average and higher than its one standard deviation. It is currently trading at 4.06 times compared to an average of 2.03 times and a median of 1.68 times. Hence, we believe that the current valuation looks a bit stretched. 

But before concluding anything we can check another valuation metric, which is the dividend yield, to arrive at the short-term attractiveness of the index. Higher the dividend yield better is the attractiveness of the index or company. It needs to be analysed in contrast to the earlier two matrices, PE and PBV. The current dividend yield of Nifty Small-Cap index is at 0.81 per cent, compared to the long-term average of 1.2 per cent. This metric is also trading at around one standard deviation lower than its long-term average. Hence, purely from valuation matrices, it currently looks overvalued. 

Now let us do a comparative analysis of the small-cap index with the Large-Cap index. To do so, we will take the ratio of Nifty Small-Cap 250 to Nifty 100 to understand where we are historically. The graph below gives you a graphical representation of the ratio since 2005. Currently, the ratio is at two standard deviations above the long-term mean. Historically, we have seen that once this ratio is reached, the small-cap index underperforms the large-cap index and hence the ratio starts coming down. 

Therefore, from a short-term perspective, small-cap investments may not be in an ideal position. Investors willing to invest in small-cap stocks should consider waiting before committing their funds. One indicator supporting this caution is the ratio of small-cap market capitalisation to large-cap market capitalisation. Currently, the share of small-cap market capitalisation as a percentage of large-cap market capitalisation is at 8.41 per cent, compared to an average of 4.8 per cent since 2005. Historically, when this ratio exceeds 7 per cent, it signals a need for caution. Additionally, the profit share of small-caps relative to large-caps is still lower compared to their market capitalisation share. 

Long-Term Investor
According to a research report by a prominent domestic brokerage firm, the earnings growth for the Nifty Small-Cap 100 is projected to be 25 per cent for period FY23 to FY26. In comparison, the benchmark Nifty is expected to see a growth of 17 per cent. One reason for the anticipated strong performance of the broader indices is their higher weightage in the industrial sector and discretionary consumption space, which are poised to benefit from the current demand environment driven by the capital expenditure cycle and discretionary spending, as noted in the report. 

The report highlights that the Nifty Small-Cap 100 index allocates 38.38 per cent of its weightage to capital expenditure and manufacturing-related companies. This significant allocation to capital expenditure and manufacturing sectors is likely a key factor behind the strong performance of the small-cap indices. From a long-term perspective, the report suggests that the maximum potential upside in terms of PAT and GDP for the small-caps is much higher. It has currently reached 0.7 per cent of the GDP, compared to the cycle peak of 1.2 per cent. 

This shows there is room left for gain among the small-cap stocks. Also, in the past cycles, the average time from the bottom to peak has been around 18-24 months and the average upside has been 2-3 times. The current rally is at 11 months with 1.8 times returns indicating scope for a further rally. If we take a longer term horizon, the small-cap index has generated returns on a median basis of around 11 per cent every five years. 

Plan of Action If you are willing to commit funds for a longer horizon, it is important to focus on the higher earnings growth expected rather than over-analysing the valuations. Estimates of high earnings growth, participation in market-favoured themes and dedicated investment flows suggest that the small-cap stocks remain attractive. Long-term investors with a horizon of one to over five years should consider investing in this category of stocks. The optimism is further supported by the fact that hot investment themes such as manufacturing, capital goods and niche high-growth businesses in healthcare and IT companies are often represented by smaller companies. 

Empirical evidence indicates that the triggers for the bear markets within small-caps (over 20 per cent fall) typically stem from highvaluation zones, followed by a slump in economic growth and/or a monetary tightening cycle. Both appear unlikely given the recent upgrades to India’s GDP and a benign interest rate outlook. Our outlook for small-cap indices remains optimistic. Despite a noticeable decrease in the risk-free interest rate, which supports higher equity multiples, the valuations do not appear frothy. Being mindful of valuations and selective in stock-picking will likely be crucial for outperformance in 2024. 

Methodology
To come up with a list of performing small-cap stocks, we took into consideration five crucial parameters. The first includes market capitalization. The second and third parameters obtained from the Profit & Loss Account include Sales, Operating Profit and Net Profit. We have also taken into consideration the efficiency of the companies by analyzing profit margins. Each parameter was then ranked by awarding it a carefully determined weightage based on its significance. 

We then segregated the small-cap companies into three categories as follows:
■ Turnaround Performance: These companies include those that successfully managed to turnaround the losses incurred in FY22 into profits in FY23.
■ Improving Financials: Although these companies still reported losses in FY23 as they did in FY22, they succeeded in reducing these losses by a notable amount. This indicates that they are on the road to recovery.
■ Thriving Companies: This list includes all those companies that have seen their profits increasing on yearly basis for FY22. 

All the raw financial data is sourced from Ace Equity and price-related information is as of May 24, 2024.