Smallcaps' valuation surpasses that of largecaps for first time in over a decade, time to turn cautious?

Mihir Vora, Director & CIO, Max Life Insurance, in a tweet said valuations of India's smallcaps exceeded those of largecaps for the first time in more than a decade.

As Nitin Shahi, Executive Director, FINDOC, said the Nifty is trading at 29-30 P/E FY21 & 24-25P/E 2022 forward multiple (EPS estimated for FY22 - 650).

A correction of 7-9 percent couldn’t be ruled out as historical data suggests an average P/E at 21-22 over the last 10 years, Shahi said.

Analysts agree that the market is overvalued.

"Going by the popular norms of valuation—market cap to GDP, PE ratio, price to book—markets are overvalued. Market cap to GDP ratio, considered very important by Warren Buffet, is above 100 percent," VK Vijayakumar, Chief Investment Strategist, Geojit Financial Sevices, said.

This could be normal for developed markets but not for a developing country. PE is around 40 percent higher than the 20 years' median valuation and PB 25 percent higher than the median valuation, Vijayakumar said, referring to price-to-earnings and price-to-book ratios.

Time to turn cautious?

In the last few days, prices of small and mid-cap stocks have gone up sharply as compared to their book values and that’s the reason a majority of investors are cautious.

"In the past, whenever we came across such type of a trend we saw serious profit-taking in the market. Retail participation is more than institutions that lead to a euphoric rise in the market. However, we need to measure our investments in terms of returns or profitability ratios that give more clarity about the valuation of the companies," said Shrikant Chouhan, Executive Vice President, Equity Technical Research at Kotak Securities.

The market trend is a concern for stocks or companies lagging the rally in strong companies in that sector. For buying or investing in mid-cap companies, investors should analyse their fundamentals thoroughly, Chouhan said.

Growth should be visible or there must be some basis for the vision of the company, he said. Investing in mid and smallcap stocks is a timeless strategy but there is a need to keep a close watch on circulars the companies submit to exchanges.

The higher valuations can be partly justified in the present “new normal”, where returns from alternate asset classes are very low, Vijayakumar said.

"Humungous liquidity created by the Fed and other leading central banks of the world has created this asset-price inflation. Hyper trading activity by retail investors trading from home is another factor imparting resilience to markets even at high valuations," he said.

Liquidity and retail investors are unlikely to leave the market in a hurry. Therefore, overvaluation may remain for some time. “Perhaps, more importantly, if growth and earnings rebound sharply as the market expects, valuations will come down," Vijayakumar said.

Many mid and small-caps have higher growth potential compared to largecaps and, therefore, higher valuations may be justified.

But a worrying development is that many single-digit stocks have been rising by 5 to 10 percent a day.

"Retail investors investing in such stocks will come to grief. High valuations of mid and small-caps are certainly an area of concern. When a sharp market correction sets in, mid and small-caps will suffer a disproportionate crash in prices since this segment lacks depth," Vijayakumar said.

Rich valuations may trigger some correction in mid and small-cap space and one buying on dips with a long-term perspective may be an ideal strategy.

"Mid and small-caps will see some time-wise correction over the next few quarters. A better strategy is to invest a partial amount on every fall of three-four percent in the index for the time horizon of two-three years," said Shahi.

Mid and small-caps can outperform largecaps in the next two-three years but one must look at individual stocks rather than the index, he said. There are always green shoot sectors available even if markets are not performing. Infra, agriculture, specialty chemicals and cement are the sectors where demand is not a concern for the next couple of years and can be added to the portfolio, Shahi said.

Disclaimer: The views and investment tips expressed by experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.