This post is co-authored by Nihit Kshatriya & Jay Dhruv.
The BSE Smallcap 250 index has been zooming after the covid crash of 2020. There was a hiatus for 15 months in the middle, but the rally is back now.
You don’t want to miss the rally, so you stick with your SIPs but are also concerned about frothy valuations. I guess the term “cautiously optimistic” fits this situation well.
In this post, we try to answer one key question for the “cautiously optimistic” investor: Yes, Smallcap stocks are frothy, but by how much?
We will analyse the smallcap space using the BSE 250 Index and BSE Smallcap Index by examining valuations (P/E), Earnings, and index movement.
Please note a few points before we dive in:
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- BSE Smallcap represents the bottom 15% free float of the market (currently ~1000 stocks). We have used this for long-term trends since data has been available since 2005.
- BSE 250 Index represents stocks ranked 251 to 500 based on free float. We have used this to contextualise the trend in the set of stocks against which most smallcap mutual funds are benchmarked. Data available since 2017.
- We have not taken the Nifty 250 index because they changed PE calculation methodology in 2021, so numbers are not comparable pre and post-2021. The BSE 250 index is a good proxy for the NSE 250 index.
- We will regularly draw comparisons with Nifty 50 since it’s a popularly tracked index that provides better context.
Putting the Smallcap rally in perspective
The chart below shows the returns of the BSE Smallcap Index, which typically represents the bottom 15% of stocks by free float.
On a one-year rolling returns basis, this broad index (which is ~1000 stocks) is showing a cool 64% increase, which is not exceptional. This index is known to rise and fall sharply. The red shaded region indicates the observations in the 4th quartile, which means the returns displayed here are among the top 25% observations. The subsequent colours represent the lower quartiles.
But, when pegged against the Nifty 50, the recent surge in the Smallcap Index is significant.
The ratio of the BSE Smallcap Index and Nifty 50 is currently on the higher side of the 4th quartile, as against the historical trend.
BSE 250 Smallcap: P/E Ratio & Earnings Growth
Simply put, the P/E ratio indicates the amount an investor should invest in a company to receive Rs 1 of that company’s earnings. If a company trades at a P/E multiple of 20x, investors are paying Rs 20 for Rs 1 of current earnings. It would also take the investor 20 years to re-coup his investment if the company keeps its earnings constant.
The P/E ratio of the BSE Smallcap 250 index is 34.5 due to a steep rise in the last 15 months. P/E multiple data for BSE Smallcap 250 index is available since Jan 2018 with very high P/E observations in the beginning and hence the quartile range is skewed upwards. If we normalise the effect of the starting point, the P/E multiple is on the higher side.
Over the last four years, the percentage of stocks with PE less than 30 has reduced from 75% to 37%. This is why many fund managers say, ” It is harder to find good stocks.” However, this data also does not suggest that things are alarmingly bad.
The PE ratio isn’t alarming. What about earning?
The expansion of the BSE 250 P/E multiple in the last year is mostly due to price increases. In the last year, the P/E multiple has expanded by 63%, whereas Earnings Per Share (EPS) is flat at -3 %. Moreover, as the chart shows, EPS has been flat for the last 20 months or so, whereas the P/E multiple has kept expanding.
This implies that there is higher probability of price correction in the Smallcap Index if earnings don’t catch up. But, earnings have caught up in the past 5 years especially after a PE expansion, as history tells us. We need to keep an eye on earnings to see how long will this rally sustain.
Though the data is limited (just 7 years), we did a simulation of how investing in P/E ranges, in the BSE 250 Smallcap Index, has turned out. It is apparent that nothing good comes when you invest in the Smallcap Index when P/E multiples are above 30.
Why P/E ratio is important
The P/E multiple is the most widely used basic valuation metrics. It tells you how much money you are paying to earn a dollar today. Higher P/E multiples are justified by anticipated earnings growth, while lower P/E multiples are justified by looming business risks.
Often, in booming markets, business risks are forgotten, and bad stocks start getting higher P/E. We must realise that just because stock markets are booming, the actual operational risks of running a business do not go away.
In July 2023, we published a post highlighting how stocks can compound their revenue. In the chart below, notice how the odds of compounding revenue by 20% CAGR keep dropping after the first two deciles of revenue ranges.
Now consider, however difficult, that you are able to spot a company that is able to deliver 20% CAGR earnings growth for ten years. We ran numbers to check how much returns you would make after you paid a certain P/E for that stock?
How to read the chart:
- P/E multiple on the left indicate the PE at which you buy
- Percentages on top represent ten years earnings growth CAGR
- Values in the table represent your returns when you sell at an exit PE of 30
So, if you invest in a stock at 70 P/E and it gives you 20% CAGR earnings growth for 10 years, your returns after 10 years will still be 10% CAGR if you exit the stock at 30 PE. You might as well have invested in a 10% growth company with a 30 P/E.
To sum it up, Things to consider while investing in smallcaps
1. Don’t Over-allocate to small caps
Don’t go all in on small-cap stocks. There is never a good time to go all in on any strategy. When markets are booming, investors are seduced to think that they have found “the answer” to making supernormal returns and over-allocate to such a strategy. Looking at chatter on social media and offline, it seems that this time, small-cap stocks have captured such a fancy.
Prudent diversifications within strategies will help you build a healthy portfolio that can wither the storms and let you be invested for a long. Yes, it’s boring, but the damn thing works.
2. There will be pain
Data shows that smallcap stocks can be more volatile than largecap stocks. Markets move in cycles, so you need to give your portfolio enough time to live through the bad phase and give rewards in the good phase.
If you take out capital during a down cycle, you lose the returns you make when the cycle turns. Imagine selling something at the bottom of the COVID-19 crash or 2008 crash or such. Morgan Housel says it best:
The most important question to ask when thinking about risk isn’t how much volatility or upside you’re looking for. But how much time do your emotions and goals need to survive that volatility and upside to play out?
Smallcap stocks have deeper and longer drawdowns when compared to largecap stocks. Imagine being allocated to stocks from an index that goes through a nine year drawdown from peak. Not everyone can handle this.
3. Stock picking is key
If you check for two key parameters and remove these stocks from the Smallcap Index, the overall returns should improve.
Junk stocks: Typically, smallcap stocks have “relaxed” corporate governance standards because they are not as widely followed and scrutinised. The disclosures are also the bare minimum, so investors have less information as compared to largecap stocks. This increases the risk of picking up junk stock due to lack of information or misinformation.
Illiquid stocks: Buying a stock is straightforward: Someone sells you a stock at a price, and you click buy. But we occasionally forget that one day, we will need a buyer at the other end to complete our trade (or investment). Smaller stocks can become illiquid for periods of time and may quickly lose value. If you keep investing in illiquid or low-float stocks, surely you may see sharp rises, but more often, the falls are sharper.
For these two reasons, stock picking is critical when investing in smallcap space. Different from largecaps, simply buying the index does not work out as well as picking better stocks. This is why actively managed smallcap mutual funds do better than the index while active largecap mutual funds are hugging the index.
4. Build a portfolio
If done right, concentrated bets on smallcap stocks can give phenomenal returns. But that’s an exception and not the norm. If you are not an exceptional stock picker who can handle large drawdowns, it is not a good idea to build a concentrated portfolio. At Capitalmind, we believe that a diversified portfolio works best for long-term investing, especially when it comes to smallcaps. So either go with mutual funds or build a portfolio of at least 20 stocks. Oh, and if you wish to go YOLO, do it with a week’s of your income – not more 🙂
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