Here's why small-caps could power the market rally in coming days

Devanghshu Datta looks at the historical trends and explains why there is room for an outperformance from smaller stocks, especially the small-caps

The stock market recovery in the past 11 months has been astonishing. Despite an economic contraction, the National Stock Exchange (NSE) Nifty and BSE Sensex have hit all-time highs and the big stock indices have roughly doubled from the lows hit after the announcement of the first lockdown in March 2020. 

Given the visibility of a continuing corporate recovery, and a Budget perceived as market-friendly, could the markets see a further rally? Although valuations are high, there are supporting factors to sustain a continuing rally. Moreover that rally is likely to see outperformance from smaller stocks, especially the small-caps. 

Since January 2019, the Nifty has returned 39 per cent, and the Nifty Large-Midcaps 250 Index 36 per cent. However, the Nifty Smallcap250 index has given a lower return of 24.7 per cent during the same period. Calendar 2019 was very poor for small-caps, with an 8.5 per cent loss for the index. 

There’s been a strong recovery in all three indices since the March 2020 lows. The Nifty has returned 96 per cent, as mentioned, while Mid-caps have returned 98.5 per cent and the Small-caps a whopping 118 per cent. 

Here are the reasons why we feel Small-caps may outperform. Historically, small stocks have suffered greater losses during downturns, and that has happened this time too. However, when markets rebound, smaller stocks also tend to see a sharper rise, and that could be happening now as well. 

There are many explanations for this. One is that there are low institutional stakes in small-caps, which means there is usually more selling during a downturn. This is because retail investors can panic. A second explanation is that smaller businesses get hit harder during recessions, since they have fewer defensive cushions in terms of reserves to absorb losses, or diversified customer bases. This makes them more vulnerable. 

If we look at the investment patterns of the current financial year, it’s clear that foreign portfolio investors (FPIs) – big overseas investors – have driven the market. FPIs’ equity buying hit Rs 2.48 trillion between April 20 and February 05, 2021, while domestic institutions sold Rs 1.26 trillion worth of equity during the same period. Equity mutual funds saw lower net inflows between April and September 2020 and net outflows during the October-January period. Equity mutual investments are largely driven by retail investors. 

When equity fund inflows are down, retail interest is also low. A strongly positive response to the Budget and continuing economic recovery could trigger new retail enthusiasm. In addition, domestic institutions could see a shift in attitude given the more optimistic situation and the fact that interest rates remain low and liquidity is high. That should translate into strong small-cap performance because domestic institutional investors (DIIs) and retail investors are more likely to focus on smaller stocks than FPIs.

In terms of valuations, we have an interesting situation. The Nifty price to earnings (PE), as released by the NSE, is calculated on the basis of last four quarters weighted according to free-float like the index. That PE is currently running at 41.46, with the price-to-book-value (PBV) at 4.2 and the dividend yield at 1.06 per cent. 

The small-caps have similar valuations in terms of PE but lower PBV and higher dividend yields. Dividend is actually significant at the moment due to low interest rates. The mid-caps are at an extraordinarily rich valuation of PE 53x, although the PBV and dividend yields are better than the Nifty. While investors will look at company-specific ratios, anybody seeking value will probably focus more on the small-caps segment. 

In terms of purely technical indicators, all three indices are strongly bullish and trending up. They are running well above their respective 200-day moving averages. That’s usually the signal of a healthy bull-market trend. They are also above their respective 50-day and 20-day averages which means the short-term and medium-term trends are also bullish. When a strong trend like this is established, it can continue indefinitely, and while big stocks will do well as the trend lasts, investors focusing on smaller stocks could get even higher returns.