Is small-cap party over? CapitalMind cautions investors on correction risk

Higher probability of price correction in Smallcap Index, if earnings don't catch up, infers a study by Capitalmind Financial Services

The BSE Smallcap 250 index has been on a tear since the 2020 market crash, with a notable pause between January 2022 and March 2023. However, the rally reignited since April 2023.

A recent study by Capitalmind Financial Services, Sebi registered portfolio manager, has raised concerns about the sustainability of this surge. The index's P/E ratio has expanded by a significant 63% in the past year, while earnings per share (EPS) remained flat, indicating that the price increase is not backed by strong fundamentals.

"In the one-year period ending 11th July 2024, the P/E multiple of BSE Smallcap 250 has expanded by 63%, whereas Earnings Per Share (EPS) is flat at -3 %. This showcases the expansion of the P/E multiple of BSE Smallcap 250 in the last year is mostly due to the increase in price. The continued flat trajectory in the earnings could escalate to a high probability scenario of price correction in smallcap index," noted the study.

This disconnect between valuation and earnings growth raises the specter of a potential price correction in the small-cap index. Capital Mind has advised investors to exercise caution and conduct thorough due diligence before investing in small-cap stocks.

The analysis by Capitalmind revealed a concerning trend in the BSE Smallcap 250 index. The study found that the index has historically delivered better returns when its P/E ratio was below 20. However, over the past four years, there has been a significant shift towards higher valuations. 

Analysing the data for the period 1 December 2017 to 11 July 2024, Capitalmind infers that median six months returns is best when the PE ratio is below 20 with median 6 months returns at 25.2%. The median 6 months returns turns negative as the PE ratio moves upwards of 30. The worst median 6 months returns is in the PE ratio range of 35-40.

Over the last four years, during July 2020 to July 2024, the percentage of stocks with PE less than 30 has reduced from 76% to 37%. During the same period, the PE range between 30 to 50 has increased from 13 per cent in July 2020 to 29 per cent in July 2024. During the same period, PE range of more than 50 has moved up from 11 per cent to 33 per cent. 

Key Findings:

• Historical Performance: The index has demonstrated better returns when its P/E ratio was below 20.
• Valuation Expansion: The percentage of stocks with a P/E ratio above 30 has increased substantially in the last four years, indicating a potential overvaluation.
• Rising Risk: The growing number of stocks with P/E ratios exceeding 50 highlights the elevated risk in the small-cap space.

Capitalmind Financial Services shares following advisory to investors while investing in small caps:

1. Don’t Over-allocate to small caps

Don’t go all in on small-cap stocks. There is never a good time to go all in on any strategy. Prudent diversifications within strategies will help one build a healthy portfolio that can wither the storms and it is better to be invested for a long.

2. There will be pain, small caps will remain volatile

Smallcap stocks have deeper and longer drawdowns when compared to large cap stocks. Markets move in cycles, so one needs to give their portfolio enough time to live through the bad phase and give rewards in the good phase.

3. Stock picking is key

Different from largecaps, simply buying the index does not work out as well as picking better stocks. This is why actively managed smallcap mutual funds do better than the index while active largecap mutual funds are hugging the index.

4. Build a portfolio

A diversified portfolio works best for long-term investing, especially when it comes to smallcaps. So, either go with mutual funds or build a portfolio of at least 20 stocks