Where we are wrong in understanding Midcap & Small cap valuations?

 

The biggest question in the minds of every investor is what about the current investments and forward investments in the Midcap and small-cap space.  The media was flooded with a statement from a well-reputed CIO to stop current Sips in small-cap and midcap. He has forgotten that his own AMC has SIP trigger options and also sip is a long-term bet linked with goal planning. His statement will only create trouble for the investment advisors and the MFD community. Since clients follow herd mentality any such statement from such a reputed house is bound to create panic. 

The current market fallout has led to significant erosion of returns from the SIPs in the last 1 year and even 2 years.  Now this statement adds fuel to the fire.  Many midcaps and small-cap Funds that hit the capital market in CY 24 are now below Rs 10, but does that mean midcap and small-cap will not find growth in the coming FY -26? The biggest risk for the market is that we have a new breed of 15.5 cr new demat account holders added in the market in the last 4 years who are witnessing correction for the 1^st time. It's time for investor education. The Nifty Midcap 100 index has fallen by approximately 14% from its peak whereas the  Nifty Smallcap 100 index has experienced a decline of about 16% from its peak in September 2024.

Before that, we need to know where the segment of Midcap and small cap is standing and its valuations, P/E ratio, PEG ratio etc.

Current Valuation Status:

1)   Mid-cap and Small-cap Indices Corrections: Recent reports indicate that the Nifty Midcap 100 and Nifty Smallcap 100 have corrected by 14% and 16% respectively from their peaks in September 2024, suggesting a significant pullback from high valuations.

2)   Despite the correction, these indices are still trading at a premium compared to the Nifty 50, with midcaps at a 45% premium and small caps at a 7.5% premium

  

Now where we are going wrong in terms of valuations in Midcap and small cap space.

The current Price-to-Earnings (P/E) ratio for mid-cap stocks, specifically those in the Nifty Midcap 100 index, is around 45. This represents a 45% premium over the Nifty 50's P/E ratio, indicating that mid-caps are trading at significantly higher valuations compared to large-cap stocks.

On the other hand  for small-cap stocks within the Nifty Smallcap 100 index, the P/E ratio stands at about 32, which is a 7.5% premium over the Nifty 50. This suggests that even after some correction in valuations, small-cap stocks are still trading at elevated levels compared to historical averages or large-cap stocks.

Many analysts and market participants are getting confused that the current fallout is still left for the Midcap and small-cap segment riding on the valuation horse. We are failing to look beyond the top expensive stocks in the categories of midcap and small-cap.  Removing the top 15 expensive companies from these indices shows more reasonable forward PE ratios, suggesting there might be opportunities for those not chasing the most overvalued names.

Now when we remove the most expensive stocks from indices like Midcap-100 and Smallcap-100 show more favourable forward P/E ratios (24.5x for midcaps and 20.8x for small-caps), indicating opportunities might exist outside the most overvalued stocks.

Coming to the PEG ratio it is found that the same is calculated by dividing the P/E with forward growth. Now under the current circumstances, one might be looking at the top stocks of midcap and small cap space instead of removing the high valuations stocks.

For both midcap and small-cap given the high P/E, without corresponding high growth forecasts, the PEG could be above 1, suggesting they might be overvalued if growth doesn't meet expectations. This is the place where we are getting confused and just getting obsessed with the top midcap and small-cap overvalued positions.

In January 2025 alone, FIIs sold nearly ₹80,000 crore worth of Indian equities from the secondary markets, with a considerable portion likely coming from midcap stocks, given the general market trends. This amplified more sales from mutual funds and domestic investors' portfolios.

 Now the next doubt is that recovery will take time in the midcap and small cap space. We are doing this comparison with 2017 to 2020 when the segment was beaten down due to Demonetization, the ILFS crisis, the PMC bank failure and the DHFL crisis.  The current time is different and hence the recovery will be normal and will not repeat its history. But yes as a client or investor, one should have reduced expectations of returns

 Between August 2023 to  June 2024, we witnessed a massive inflow of funds in thematic sectors like defence, manufacturing, energy, power, innovation, PSU, and Infrastructure funds to the tune of altogether around Rs 1.4lakh cr. This money came into the market when the valuations were all-time high hence one needs to give some time to the Fund managers and financial advisors to regain the lost ground over time.  This does not mean these thematic don’t have any future.  The only barrier is the return expectation and the time frame of the expectation.

Moving on to the average returns of small-cap funds between December 2023 and December 2024, they stood at 25.69%. In comparison, mid-cap and large-cap funds gave returns of 26.91% and 14.97% respectively during the same period.

Going forward sectors like manufacturing, renewable power, luxury discretionary products, premium consumption (real estate, liquor, airlines, hotels, jewellery), healthcare, infrastructure, construction, and defence are highlighted for potential growth in 2025, which could influence investment decisions in these market segments. The budget followed by taxation relaxation will benefit the sectors in multiple ways. Just calculate that family of 2 where both are earning remember having less than 12lakhs income each, what type of consumption surplus they will have in hand which will get into the market.

 Here's an overview of Foreign Institutional Investors (FIIs) that have notably sold midcap and small-cap stocks in India from September 2024 to January 2025:

• Europacific Growth Fund - Sold approximately ₹32,391 crore.
• Government of Singapore - Sold around ₹24,421 crore.
• GQG Partners - Disposed of roughly ₹15,072 crore.
• Vanguard International - Sold about ₹7,327 crore.
• Fidelity Trust - Sold around ₹3,010 crore.
• Green Invest - Sold approximately ₹2,440 crore.
• SmallCap World Fund - Sold roughly ₹2,411 crore.
• DF Partners - Sold around ₹2,328 crore.
• JPMorgan Fund - Sold approximately ₹1,705 crore.

(collected from various sources)

Conclusion:

Stay invested in midcap and small-cap and rather double your SIP investments during the current time.  Have reduced return expectations and focus on long-term wealth creation.  This is not 2017 to 2020 for the market. Falling interest rates will add more earnings and will improve the margins for the midcap and small-cap.   Large caps will deliver more returns which did not deliver in the last 2 years since the focus was extensively towards thematic and mico caps. Now penny stocks will lose focus and a large cap, good valuations and strong fundamentals will play until the next rally for penny stocks.

 The mid-cap and small-cap market segments in India are currently characterized by high valuations that have corrected somewhat but remain elevated compared to historical norms. The outlook for 2025 suggests a cautious investment strategy, focusing on quality, earnings growth, and selective investments to mitigate risks associated with potential market consolidation or volatility due to these valuations. Investors are recommended to diversify, with an eye on sectors likely to benefit from ongoing economic trends and policy directions.