The Behavioural Trap of P/E while investing in Midcap and Small cap

 

Investors are still sceptical about investments in the midcap and small-cap space.  Is this the correct time to invest in midcap and small when the P/E is still high?  Is the current P/E justified? Are we, as investors and financial advisors are getting too carried away by P/E behavioural impact? Have we all created enough negative rationales for not investing in midcap and small cap under the current valuations, under the notion of further corrections?  The list of questions is endless. The fact is we are caught in the behavioural aspect of P/E ratio for investing and not going beyond the same to see more clearly and identify opportunities.

The most popular barometer for the segment is P/E. The Nifty Midcap 100 P/E is 33.5x (as of May 16, 2025), above its 5-year average (30.7x). The Nifty Small-cap 250 P/E is approximately 30.0x–32.0x. These P/E numbers raise the risk level of investors doing investments in the mid-cap and small-cap space. But the irony is that when we do investments, we do for 5 to 10 years, and by rule, this segment has a standard practice of investments of 5 to 10 years.  Then, how do the current P/E levels raise questions in the mind? Are financial advisors doing analysis and treating mutual fund investments just like direct equities? If that is the case, then we must accept that financial planning and advisory has gone for a toss and mutual investment guidance has become just like equities, where more complexity under the disguise of better returns is being compounded.

P/E is just a blind spot to be used as a navigation star for investments, since P/E has become more of a behavioural aspect for decision making rather than one that finds the reasons for the continuities behind the P/E ratio.

2018-19  was one of the most memorable periods for the Indian economy and financial market. The IL&FS crisis, DHFL crisis,  PMS bank collapse, liquidity constraints in the NBFC sector, and foreign institutional investor (FII) outflows.  Banks were having higher non-performing assets, which created more pressure on the asset performance. GNPA ratio of 14.58% was communicated by the RBI during 2018-19.  This reflects that companies struggled during these times with business growth opportunities, followed by a liquidity crisis and a flow of capital within the economy.

In 2018, mid-caps were still grappling with high debt levels, particularly in capital-intensive sectors like infrastructure. For example, companies like Jaiprakash Associates Ltd. had significant liabilities (~$10 billion), contributing to elevated D/E ratios. Small-cap companies, ranked 251st and beyond with market caps typically below ₹5,000 crore, had higher D/E ratios than mid-caps in 2018, reflecting their reliance on debt to fuel growth as newer or smaller entities.

Sectors like real estate, infrastructure, and manufacturing, which include many small-caps, had higher D/E ratios due to capital intensity. In the midcap space, the debt-to-asset ratio (total debt divided by total assets) for mid-caps in 2018-19 was typically 0.3–0.6, reflecting moderate asset-backed borrowing. Similarly, the small-caps had debt-to-asset ratios of 0.4–0.8, higher than mid-caps due to greater reliance on debt relative to their smaller asset base.

In 2019, the Nifty Midcap 100 P/E increased to approximately 28.0x–30.0x, driven by improved sentiment and expectations of earnings recovery. The Nifty Smallcap 250 P/E rose to around 22.0x–24.0x, recovering from 2018 lows but remaining below mid-caps. Small-caps were still seen as riskier, with valuations reflecting cautious optimism.

In 2025, the banking industry, the  Public Sector Banks (PSBs)  GNPA ratio around 3.7% expected to rise to 4.1% by March 2025 under a severe stress scenario, whereas the private Sector Banks (PVBs) GNPA ratio is approximately 1.8%. The decline in NPAs reflects improved asset quality, higher write-offs, and steady credit demand, with no top 100 borrowers classified as NPAs in September 2025. Compared to 2018 (GNPA: 11.18%, PSBs: 14.58%), the 2025 figures show significant improvement. When NPA numbers are low, then the risk of business operations for midcap and small cap companies operating efficiency is healthy. This is getting reflected in the current P/E ratio. Now, based on the traditional theory of P/E, we will miss out on doing investments under the current volatile opportunities being offered by the segment.

During 2018, the Nifty Midcap 100 index saw negative or flat profit growth for many constituents, with an estimated net profit CAGR of 0–5% for the fiscal year ending March 2018, heavily impacted by sectors like infrastructure and financials.  Small-cap companies also struggled in 2018.  The Nifty Small-cap 250 index saw negative or minimal profit growth, with an estimated net profit CAGR of -5% to 0% for FY18.

In 2025, the Mid-caps have shown strong long-term profit growth from 2020–2025, with a 5-year net profit CAGR of 20–25% for the Nifty Midcap 100/150. Small-caps have shown exceptional long-term profit growth, with a 5-year net profit CAGR of 25–30% for the Nifty Small-cap 250 (2020–2025), outpacing mid-caps and large-caps (Nifty 50: ~15–20%).

Hence, the period of 2025 is different, and one cannot avoid investing under the notion of the high valuation of the current P/E of the segment. The current P/E levels are well justified for investing in the midcap and small-cap space.   

If we exclude the top 30 companies from the Nifty 150 index, the P/E ratio will come down significantly. If we exclude the top 30 companies from the Nifty Midcap 150, we're essentially removing the largest and most premium-valued mid-caps, which typically have the following two factors

1. Attract higher institutional interest, leading to elevated prices.
2. Often command premium P/E multiples due to stronger balance sheets, higher earnings visibility, and market leadership within the mid-cap space.

If you exclude the 39.8x-weighted chunk (Top 30), the average P/E of the remaining portion would drop substantially, likely closer to 26–28x, which aligns with historical averages for mid-caps.

Hence, we are looking clearly and beyond the P/e ratio while doing investments and just gazing at the behavioural aspect of the same. It’s time to invest based on one’s risk profile and goal.