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Valuation discount of small-midcaps to large caps has dipped, not disappeared; significant loss pools distorting the picture

As per our proprietary ‘risk-spread’ framework, large caps have a trailing earnings yield of 3.5% while mid, small and micro caps continue to yield higher at 4.2%, 4.5% and 6%, respectively. While the yield spread of mid and small caps over large caps has dipped sharply since the end of CY19 due to their outperformance, it has not disappeared or turned negative, which typically coincides with the peaking out of mid and small caps. Headline P/E valuations of mid and small cap indices are significantly distorted as they currently have significant loss pools thereby optically magnifying the numbers.

On the other hand, large cap index (NIFTY50) loss pools have reduced significantly thereby, further distorting the relative valuation picture. Another system wide indicator of significant loss pools in broader markets is the ‘Profit to GDP’ ratio, which has hit a 7-year high of 3% in FY21, largely driven by large caps at 2.6% while mid and ‘small plus micro’ caps contribution is significantly compressed at 0.4% and 0% respectively. Sharp drop in the contribution to ‘PAT to GDP ratio’ is explained by the disproportionately high contribution of ‘small plus micro’ and mid-cap to the overall ‘loss pool to GDP’ of -1.2%, at -0.6% and -0.3% respectively.

* Don’t throw in the towel on mid & small caps yet: Our risk-spread framework starts with the assumption that as you go down the market cap curve, investors are taking more risk and hence, they should be adequately compensated for taking that extra risk in terms of higher returns which we measure in terms of ‘earnings yield’ and growth outlook. Hence, managing risk becomes paramount while investing in the broader market, and investors should steer clear of speculative stories which are not supported by adequate earnings yield, growth prospects and quality of business. The above has become critical especially post the significant outperformance since CY20 which has taken away a significant amount of ‘margin of safety’ from mid and small caps.

We believe as economic recovery gains traction over the next couple of years, broader market earnings growth over the latter part of FY21-23 will be robust and are expected to be higher than NIFTY50’s growth. Improving growth can support valuations in the broader market thereby, providing moderate returns (10-15%), given the reduced valuation gap with large caps. On the flip side, expectations of a sharp outperformance from mid and small caps going ahead will be belied.

* Mid and small cap picks from our coverage universe with a fundamental BUY rating and high levels of earnings yield spread over large caps (Based on our FY23 EPS estimates)

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