Small-cap index likely to witness correction if earnings don’t catch up: Capitalmind

The BSE Smallcap 250 index has experienced upward momentum following the COVID-19 crash in 2020. Seeing a hiatus for 15 months in the middle, between January 2022 and March 2023, the index has been rallying again since April 2023.

The small-cap index has surged 96 percent since April 2023 as against 34 percent rise in Sensex.

According to a recent study by Capitalmind Financial Services, the P/E multiple of the BSE Smallcap 250 has increased by 63 percent over the one-year period ending July 11, 2024, while Earnings Per Share (EPS) has remained flat at -3 percent. This suggests that the P/E multiple expansion is primarily driven by rising prices rather than earnings growth. Capitalmind warns that if earnings do not improve, there is a high probability of a price correction in the small-cap index.

Market Analysis and Insights

Capitalmind's analysis from December 1, 2017, to July 11, 2024, indicates that median six-month returns are highest when the P/E ratio is below 20, with a median return of 25.2 percent. However, median returns turn negative as the P/E ratio exceeds 30, with the worst returns observed in the 35-40 P/E range.

It further revealed that over the past four years, from July 2020 to July 2024, the percentage of stocks with a P/E ratio below 30 has decreased from 76 percent to 37 percent. During the same period, the percentage of stocks with a P/E ratio between 30 and 50 increased from 13 percent to 29 percent, and those with a P/E ratio above 50 rose from 11 percent to 33 percent.

Capitalmind's Investment Advice for Smallcaps

Avoid Over-allocating to Smallcaps

Avoid investing too heavily in small-cap stocks. Diversifying across strategies is crucial for building a resilient portfolio that can endure market fluctuations. It's advisable to invest for the long term.

Expect Volatility in Smallcaps

Small-cap stocks tend to experience deeper and longer drawdowns compared to large-cap stocks. Markets move in cycles, so patience is necessary to weather downturns and capitalise on upturns.

Stock Picking is Essential

Unlike largecaps, where index investing may suffice, actively selecting quality small-cap stocks is critical. Actively managed small-cap mutual funds often outperform the index, whereas large-cap funds tend to align closely with the index.

Build a Diversified Portfolio

Capitalmind advocates for a diversified portfolio for long-term investing, particularly in smallcaps. Investors can either choose mutual funds or construct a portfolio with at least 20 stocks.

In summary, while the BSE Smallcap 250 index has shown impressive price gains, the lack of earnings growth raises concerns about a potential price correction. Capitalmind advises investors to maintain a diversified approach, be prepared for volatility, and focus on quality stock selection to navigate the small-cap space effectively.

Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of Mint. We advise investors to check with certified experts before taking any investment decisions.