Understanding Valuations: Large Caps Vs Mid and Small Caps

153-Mahesh-Kumar-S Mahesh Kumar S.

THE PAST YEAR has been exceptionally rewarding for equity investors in India, with small-cap and mid-cap stocks outperforming the large caps. Returns of Mid and Small cap space exceeded 60 per cent each, while large caps yielded around 34 per cent.

This rally in market has left investors divided: some investors are now considering to exit the stock market because they are not sure if this good time will continue, while some others are still putting money in, hoping to get good returns. This trend is reflected in mutual fund flows, where inflows into mid and small-cap categories have dipped but remain substantial, surpassing Rs4,700 crores according to recent AMFI data for February 2024. These contrasting sentiments and actions of investors underscore the dynamic nature of equity markets, where strategy plays a pivotal role in navigating investment opportunities and risks.

Historically it has been observed that investors who chase returns often have a bad investing experience. This happens because when you chase returns, you might end up investing in stocks or areas that are already very expensive compared to their intrinsic value. Warren Buffet in his investing theories has always emphasised on the importance of not overpaying for investments, as the true value of an asset should justify its price. Hence, one of the most important parameters of investing is valuation as it helps in understanding whether a particular market cap segment is overvalued, undervalued, or fairly valued relative to its growth prospects.

Comparison of Large Cap versus Mid and Small Caps in terms of valuation

Large cap stocks generally represent those companies that are firmly established and are amongst the companies with the largest market capitalization. They often have stable earnings, established market positions, and relatively lower risk compared to mid and small caps. On the other hand, mid and small-cap stocks belong to companies with relatively smaller market capitalizations and is fundamentally not as robust and well established as the large caps.

When comparing the valuation of large cap stocks to mid and small-caps, various valuation parameters like Price-to-Earnings (PE), Price-to-Book (PB), and Market Cap to GDP ratios can be considered. However, the most used metrics are PE and PB Ratios. The Price-to-Earnings (P/E) ratio measures how much investors are paying for each unit of earnings by comparing a company’s stock price to its earnings per share. A high P/E ratio may indicate an overvalued stock, while a low ratio could suggest undervaluation.

Similarly, the Price-to-Book (P/B) ratio compares a company’s stock price to its book value per share, reflecting the market’s valuation of the company’s assets relative to its market price. It is important to note that any valuation ratio in absolute terms does not provide a clear picture and should always be analysed in a relative context. Comparing these ratios across different market cap segments helps investors assess whether stocks are priced fairly, overvalued, or undervalued.

The recent rally in mid and small-cap segments, coupled with continued flows, suggests that these flows are driving the rally more than fundamentals. Currently, the PE of Nifty 100, representing large caps, stands at 23.18, with a PB of 4.01. In contrast, midcaps have a PE of 33.63 and PB of 4.59, showing they are relatively expensive. Even small caps exhibit high valuations. The market cap share of mid and small caps exceeds their Dec 17 highs, while large caps remain near their previous low in Mar 2018. Additionally, the small cap to large cap market cap ratio has surpassed 2008 levels, indicating an overstretched rally in small caps.

Further, understanding that different market cap segments perform differently during economic cycles is crucial. For instance, small cap stocks tend to be more sensitive to economic downturns, leading to weaker performance cycles and hence they carry higher risk.

Investing in Large caps

For an investor looking to invest into large caps, one of the easiest ways is to invest in a large cap based mutual fund offering. Here, the fund manager, will invest into a set of companies from the top 100 stock universe. From the offerings available, ICICI Prudential Bluechip is one of the oldest (15+year track record) and the largest in the category. The fund has weathered several market storms and has delivered consistent returns over the years. As of March 31, 2024, the fund delivered an impressive one-year return of 42.4 per cent and a healthy return of 21.5 per cent and 17.9 per cent over three and five years respectively.

Mahesh Kumar S. Is proprietor, Dreamz Finmart. +91 9842526928