December 2023 / Q3 FY24

01Small Caps: Just the Beginning, or End of the Road?

There has been increased media frenzy on how small caps have become extremely expensive and vulnerable, with more and more people recommending shifting to large caps instead. We take this opportunity to reflect on some of the facts and share our perspective.

1ABreaking the Valuation Labyrinth — Our Genre Still Trades at Reasonable Valuations

With markets making new highs, there has been increased noise on valuations being rich across the board. Media reports suggest that large-cap companies are better poised in terms of valuations than small caps — primarily because of the run-up in small-cap names. However, this needs to be understood in the right context.

The consensus seems to be that the Nifty currently trades at a 12-month forward P/E of ~19.6×, which is below its 10-year average of 20.2× and marginally higher than its 5-year average of 19.1×. Likewise, the Nifty Small Cap 250 Index seems to be trading at 21.8× currently — higher than its 5-year average of 18×[4].

In our opinion, the 5-year average may not be the right indicator of valuation matrix to begin with — it includes the black swan event of COVID, making the averages quite erratic. Further, while one looks at the benchmark index as a lighthouse to get a sense of valuations, the index itself has limitations due to the smaller representation of companies, which can again present erratic outcomes.

We analysed a broad base of companies based on their market cap to get a better sense of where we stand vis-à-vis 10-year valuations:

This is the genre where we still continue to find enough opportunities. While at that, there is indeed exuberance in some pockets of the market — which we discuss next.

1BExuberance Indeed — But Only in Certain Pockets

We have seen massive liquidity chasing stocks in certain pockets of the market, leading to exuberance there. These include:

SME Exchange

Over the last year, the SME Exchange has seen over 164 IPOs, looking to raise ₹4,425 cr cumulatively — but receiving bids worth ₹2,80,000 cr[10]. We share a sample of recent IPOs and their performance:

For relatively smaller companies with limited existential history and paltry profits, this kind of exuberance is surely unnerving. We have seen stocks going up 3–10× over the last year in this segment without any substantial change in fundamentals — just future promises being sold.

Larger Small Caps / Mid Caps

SIPs hit a record ₹17,610 cr for the month of December 2023, with overall SIPs growing 23% from ₹1,49,437 cr in CY22 to ₹1,83,741 cr in CY23[6]. Interestingly, a major chunk of these flows have found their way into Small Cap, Mid Cap, and Value / Contra funds:

Likewise, Small Cap–focused PMSs have also seen major traction during the last year, with assets swelling substantially. A close analysis of these “Small Cap” mutual funds suggests that most are focused on relatively larger small caps / mid caps, with average market caps of investee companies ranging from ₹4,000 cr to ₹20,000 cr:

This excess liquidity has gone into chasing the same stocks that most of these funds / PMSs are already invested in — with little new diversification. It is these stocks where one has seen significant re-rating, driving valuations to levels where future gains will be curtailed.

Margin Funding at All-Time High

Margin funding — where brokers / NBFCs fund investors for the purchase of shares against ~25% margin contribution — has been on the rise. As of January 2024 it stood at ₹54,537 cr, significantly higher than the ₹29,500 cr in January 2023 and just ₹7,100 cr in February 2020[10]. This only shows the kind of exuberance from the recent upside in markets, leading people to leverage and invest more in hopes of making faster money. This kind of greed is never sustainable in the long run.

02Liquidity Is Here to Stay

Despite continuous doubts being raised on the sustainability of domestic inflows, SIPs have only been increasing month after month. We believe there are structural changes on the ground ensuring this increased participation, and strongly feel this is going to only get better:

New-Gen Moving Away from the Parallel Economy

As Millennials and Gen Z take over the reins of family wealth from the Baby Boomers and Gen X, there has been an increased affinity to move away from the parallel economy. This shift has led to increased participation in financial assets, with a large chunk finding its way to capital markets.

Increasing Education and Awareness

“Mutual Funds Sahi Hai” has become a kind of clarion call. Regulator-led mass awareness, combined with the availability of multiple educational platforms, has ensured the rise of a more informed investor class — one that not only navigates volatility with calm but also increases participation in such scenarios. This is a striking contrast from the past, when retail investors were generally the first to lose confidence and sell off at the slightest volatility.

A Shift from Traditional Investments

The headline Nifty 50 has delivered ~15% CAGR over the past two decades — significantly outperforming real estate (~9%) and gold (11.2%) over the same period[8]. Consistent higher returns from equity have driven a reallocation across asset classes in favour of financial assets. The fact that financial assets are also much easier to handle and liquidate has been a strong driving factor for the shift of household savings to capital markets.

Improved Regulatory Landscape and Ease of Access

The e-KYC system has had a transformative impact on market access. As of April 2023, the cumulative number of Aadhaar e-KYC transactions surpassed 14.95 billion — expanding market reach into remote areas, and making it very easy for retail investors to participate in capital markets.

Simultaneously, SEBI has played a pivotal role in implementing crucial regulatory reforms to ensure market fairness — banning brokers from using client securities for their own loans, limiting exposure on stock leverage, linking F&O exposure to stringent margins, and proactive steps to curb insider trading. These have gone a long way to safeguard investor assets and inspire confidence.

And all this is at the retail level alone. One also needs to understand that FIIs have been continuous sellers in Indian markets for the last 3 years — selling ₹3,87,639 cr cumulatively, with another ₹23,583 cr sold by 20 January 2024 itself. As India emerges as one of the fastest-growing economies and we see interest-rate reversals coming about later in the year, we expect FII buying to return — further adding to liquidity and buoyancy.

03Corporate Earnings in a Buoyant Mode — Remember 2003–07?

In our June 2022 newsletter, we had spoken about expected buoyancy in corporate profits leading to significant wealth creation in capital markets — similar to the 2003–07 era. We are glad to share that even this prediction is playing out to perfection, as reflected in Q2 / H1 FY24 reported numbers:

We expect this growth trend to continue further, albeit at a lower rate given the higher base. Nevertheless, corporate profits should deliver ~18–20% CAGR over the next couple of years, which should continue to fuel the markets.

Small Caps Have Outperformed Recently — But Their 6-Year Returns Still Trail the Nifty

This year, the Small Cap Index has risen 62%, significantly outshining the Nifty’s 20% gain. Small caps have displayed a robust performance over the past three years. However, it is worth noting that such short-term gains often overshadow longer-term performance.

A closer look reveals that 57% of small caps’ gains in the last three years occurred in the previous year, and 94% of the six-year returns accumulated in the last year alone — amounting to a modest 5–6% annual return in the preceding five years. Even with this year’s stellar performance, small caps have not surpassed the six-year returns of large caps:

Our perspective is that the underperformance observed cannot be rectified by a mere 1–2 years of outperforming trends. Despite volatility, we foresee small caps outperforming over the next 2–3 years as part of a mean reversion over a decade — ultimately leading to their long-term outperformance.

Our conviction in small-cap stocks has been bolstered by robust investor interest in sectors like Engineering, Manufacturing, Infrastructure, Capital Goods, Railways, and Defence — sectors underrepresented among large caps and which form our core investment focus.

04Outlook on CY24

In 2024, we foresee a shift from sector-led rallies to selective stock picking driving wealth creation. While 2023 saw a general uptick across sectors, this may lead to a more cautious approach in the new year. Even as IT, Chemicals, and Textiles have not led the charge, we expect individual companies within these sectors to become key wealth generators in 2024.

2024 is starting on the backdrop of good returns. After this kind of run, it wouldn’t be out of context for the market to take a breather before it moves ahead. We believe a 5–7% correction in the headline indices is not out of context, and small caps may also see a drawdown of around 20–25% in the worst scenario.

Markets have factored in a lot of positives already — expected reduction in interest rates, growth in corporate earnings, a stable government coming back post-elections, normalisation of geopolitical issues. Any negative surprises in any of these may bring in huge volatility during the year. If such an opportunity arises, one should be ready to lap it up and build a portfolio of high-quality businesses to create wealth from a mid-to-long-term perspective.

How Are We Positioned?

Given the low base of last year, coupled with margin recovery in most businesses on account of raw material stabilisation, we saw very good growth in PAT for Q2 FY24. In fact, the buoyancy in some of our portfolio companies has positively surprised us — far exceeding our expectations. This has led us to revise profit estimates upwards for these companies.

True to our core principles of deep value investing, we have completely exited from a couple of investments where valuations ran beyond our comfort zone, and added a new company to the core portfolio. We will continue to monitor and book partial / complete profits wherever valuations run ahead of our comfort zone.

For any inquiries or feedback, please reach out to us. Follow our LinkedIn page for ongoing updates on our performance and market insights.

Sources

01

Equitree Capital — June 2023 newsletter, including the small-cap mean-reversion thesis subsequently quoted here.

02

Nuvama Custodian Services; Equitree Capital internal performance and NAV records (December 31, 2023). Returns are TWRR, net of fees and expenses, and not verified by any regulatory authority/SEBI.

03

PMS Bazaar — PMS rankings (335 schemes); APMI — PMS rankings (862 schemes), as of December 2023.

04

Motilal Oswal; Business Standard; Equitree Capital — Nifty 12-month forward P/E history; 5- and 10-year averages; Nifty Small Cap 250 valuation as of December 2023.

05

Ace Equity; Equitree Capital — segment-wise median current P/E and median 10-year P/E across market-cap buckets (above ₹50,000 cr; ₹20,000–50,000 cr; ₹5,000–20,000 cr; ₹200–5,000 cr).

06

AMFI — net inflows by equity-oriented mutual fund category, April–December 2023; SIP gross flows of ₹17,610 cr in December 2023 and ₹1,83,741 cr cumulative for CY23.

07

Value Research; Equitree Capital — AUM, number of holdings, and average market cap of investee companies for leading "Small Cap" mutual funds.

08

Statista; NSE; Bloomberg — multi-decade returns across asset classes (Nifty 50, gold, real estate); Nifty 50 vs Nifty Smallcap 100 absolute returns over 1, 3, 5, and 6 years.

09

Ace Equity; Equitree Capital — Q2 FY24 vs Q2 FY23 and H1 FY24 vs H1 FY23 reported financials (Net Sales, PAT) by market-cap bucket; data based on results declared till 19 November 2023.

10

SEBI; SME exchange listings — IPO subscription data for the SME segment (164 IPOs raising ₹4,425 cr against bids worth ₹2,80,000 cr); margin-funding outstanding history (Feb 2020 / Jan 2023 / Jan 2024).