Another milestone

Stock valuations have increased substantially

The market capitalisation of companies listed on BSE crossed the threshold of $5 trillion for the first time on Tuesday. This has made India the fifth member of the $5 trillion market-cap “club” after the US, China, Japan, and Hong Kong. At around $3.9 trillion, India has a lower gross domestic product (GDP) than the US ($25.5 trillion), China ($18 trillion) and Japan ($4.2 trillion), while Hong Kong is famously a free-market economy with a convertible currency and listings of many corporate entities based in Mainland China. Importantly, from an investor’s perspective, India’s market cap substantially exceeds its GDP. While this is not an exception — the US, for instance, has a market cap that is roughly twice its GDP — it is unusual in the Indian context. It has occurred before only at close to bull-market peaks and is usually a sign of a market being close to topping out.

It’s also notable that the recent surge in market cap has been driven by small and midcap stocks. The market cap crossed $4 trillion in November 2023 and rose another 25 per cent in the next six months. However, the benchmark largecap indices like the National Stock Exchange Nifty and the BSE Sensex are trading below their respective record highs. On average, largecap valuations in terms of fundamental ratios like price-to-earnings (PE) are lower than smallcap and midcap, even though the entire market is trading on the higher side in historical terms. The Sensex, which tracks 30 large companies with high market cap, is trading at an average PE of 22, but the Midcap 150 index is trading at an average PE of 37 and the Smallcap index at an average PE of 28. Again, these valuations are not at historical peaks, but they are on the high side. One reason why largecaps are available at lower valuations is institutional caution. Most large institutions are waiting for the result of the general elections, as well as watching for geopolitical cues arising from West Asia, and monetary policy trends in the US.

Foreign portfolio investors sold a net Rs 28,000 crore worth of Indian equity in May, following up on Rs 8,600 crore of net sales in April. The smallcap support comes largely from retail investors, who appear to be more sanguine about high valuations and more prepared to live with high risks. Much of the midcap support comes from mutual funds, which must invest if they have large inflows. Equity mutual funds received Rs 18,917 crore of net inflows in April, again mostly from retail investors. The averaged index valuations obscure the fact that many individual companies are extremely overvalued. Several fund managers have issued cautious advisories. A domestic brokerage has pointed out that there are 104 companies trading at over 50 times their PE, while nine companies are trading above 100 times their PE. This is unusual.

In terms of fundamentals, it is hard to justify such high valuations across sectors, unless there is an extraordinarily sharp acceleration in revenue growth and profitability. While guidance by managements is optimistic, there is no hint of such acceleration. It behoves investors, especially those dabbling in smaller stocks, to be cautious. The smallcap and midcap segments would be most vulnerable if there is a selloff, and that might be triggered if investors are spooked by electoral results.