Small Caps are now Historically Low in terms of Financial Leverage

In the small-cap & midcap fall of 28^th Feb 2025  the valuations, 200 days DMA and the financial leverage at the same time have come down making it more provoking for a long-term investment portfolio to be built from now.

The Nifty Smallcap 100 is down 24% and the Midcap 100 is down 21% since September 26, 2024, with 85% of BSE 200 stocks below their 200 DMA. The 200-day moving average (DMA) is a key technical indicator of long-term trends. When 85% of BSE 200 stocks (a broad index of 200 large and mid-cap companies) are below this level, it signals widespread bearish sentiment. The 200 DMA trend (85% below for BSE 200) suggests MSCI India’s 200 DMA (likely around 2,800-2,900 points based on prior levels) is a resistance level, with the index possibly trading below it (~2,600-2,700 by March 2025, assuming a 15-20% drop from 3,200). MSCI India’s P/E ratio fell from 25x in September 2024 to ~19x by February 2025, making it attractive long-term but still under pressure short-term.

With 50% of stocks down >20% and 85% below 200 DMA, MSCI India is now in the oversold zone. The fact that half of MSCI India stocks are down more than 20% since September 26, 2024, highlights a significant correction in large and mid-cap Indian equities, aligning with the broader market downturn (Nifty 50 -15.61%, Smallcap -24%, Midcap -21%). Two-thirds (~66%) of Nifty Small cap 100 (100 stocks) and Midcap 100 (100 stocks) being down 20% or more translates to ~66 stocks each.85% of BSE 200 stocks are currently below their 200 DMA; prior corrections have bottomed around 85%-90%

Now comes the leverage analysis part of small caps. The net debt ratio for small caps may have slightly risen (e.g., to 0.35-0.40) due to reduced cash reserves during the correction, but remains low compared to historical highs. Sectors like Metals and Energy might see modest increases as commodity prices stabilize, while IT and Consumer Discretionary retain low leverage. The low net debt ratio (0.29) suggests small caps are less vulnerable to debt defaults or liquidity crises than in prior corrections (e.g., 2008 or 2015, when ratios were 1.23 and 1.35). From March 2021 (0.50) to September 2024 (0.29), the overall small-cap leverage declined by 42%, driven by sectors like Utilities (-82%, from 1.10 to 0.54), Metals (stable at 0.24), and Real Estate (-39%, from 0.39 to 0.23).

The overall financial leverage across sectors has seen a significant decline from 1.35x in 2015 to 0.29x in Sep 2024. This suggests a reduction in debt levels, improved cash positions, or stronger earnings generation in small-cap companies.

  Sectors with Sharp Declines:

• Metals: Dropped from a peak of 4.32x in 2015 to just 0.24x in Sep 2024, showing a sharp deleveraging trend.
• Industrials: Declined from 1.25x (2003) to 0.11x (Sep 2024), reflecting better financial discipline.
• Consumer Discretionary: After a peak of 3.84x in 2012, it fell to 0.80x in Sep 2024, indicating reduced debt dependency.
• Utilities: This sector has historically had high leverage, but after peaking at 8.68x in 2018, it has come down significantly to 0.54x.

 Conclusion

The overall decline in leverage across small-cap sectors signals stronger financial health, reduced debt reliance, and improved cash management. The small-cap universe’s financial leverage has significantly declined to 0.29 by September 2024, the lowest in 21 years, reducing risk during the current correction. Companies have likely reduced debt in response to changing market conditions, economic cycles, and regulatory environments. The 200 DMA trend (85% below) reflects sentiment-driven selling, not leverage issues, suggesting the market may be oversold but requires catalysts for recovery. On the other hand half of MSCI India stocks are down more than 20% since September 26, 2024. While the market may be nearing a bottom (historically 85%-90% below 200 DMA), recovery depends on external and domestic catalysts. All the technical and financial aspects speak loudly its time now, but global factors will play its dice which makes the predictable unpredictable.