Small- and mid-caps have a large alpha over large-caps and valuations remain elevated, with most segments still appearing expensive relative to historical norm. This is the reason why investors might be better served by focusing on large caps as an option, a report by DSP Mutual Fund said.
Market capitalisation to GDP ratio for small- and mid-caps remains elevated. This ratio peaked at 64 per cent in September 2024 and is currently slightly over 50 per cent with its long period average at 27 per cent.
“To capture the extra alpha offered by the small- and mid-cap segments, investors are better off focusing on the margin of safety rather than relying on recent outperformance. In fact, it makes enormous sense to be aggressive in SMIDs when their alpha over large caps has vanished. Currently, SMIDs have a large alpha over large-caps, so investors might be better served by focusing more on large caps as an option,” said the report.
India Inc’s slow growth
The Q4 FY25 earnings season has shown single digit sales and profit growth for nearly 300 companies which have declared financial results, according to the fund house. The SMID cohort currently trades at about 14 per cent ROE, at 33x trailing 12-month price to earnings multiple with earnings growth in single digit for most of the last six quarters.
“This divergence between realised earnings growth trend and elevated valuations leaves little ‘margin of safety’ for investors. In the past, such elevated valuations have led to steep corrections in price or long-drawn-out time corrections which blunt rolling returns for investors. Either of these scenarios can play out. With volatility elevated, price moves on the downside can overpower the time correction likelihood,” said the report.
Indian equities have rebounded sharply from lows recorded in February. However, more stocks have made new 52-week lows than fresh 52-week highs indicating that weakness is persistent. “The number of stocks trading above 200 DMA remains weak indicating the price trends are still weak,” said the report.
Corporate India is grappling with slow single-digit sales growth, even as market sentiment remains upbeat. While the headline revenues for the Nifty 500 appear to have stabilised, this recovery has been shallow and costly, driven by capital expenditure and innovation rather than broad-based demand.
“As margins come under pressure from rising costs and weakening consumption trends, companies are finding it increasingly difficult to convert modest top-line gains into bottom-line growth. With many businesses already operating at peak margins, the room for further expansion is limited, making strong profit growth in the near term unlikely,” the report said.