Smallcap and midcap valuations are sky-high, bringing bluechips back in vogue

The frenzy in smallcap and midcap stocks this year may soon give way to the return of the blue chips owing to this crucial metric: valuations.

So far in 2024, the Nifty 50, comprising largecap companies, has delivered around 12% returns to investors, while the Nifty Midcap 100 and Nifty Smallcap 250 have delivered 22% and 25%, respectively, market data show.

But, as a result, many midcap and smallcap stocks are now highly valued with lower return potential, said Niket Shah, chief investment officer at Motilal Oswal AMC. More than half of the midcap index stocks are trading at a price-to-earnings (PE) ratio above 40, he said, indicating that these stocks may be in overvalued territory.

While some midcap and smallcap segments still offer a reasonable risk-reward ratio for investors, largecap stocks provide a much better safety net in a low-growth environment, Shah said.

Other market experts have a similar thesis: that bluechip stocks look more promising now and have higher potential than midcap and smallcap stocks, providing stability during a temporary economic slowdown.

“Although this economic softening may be short-lived as spending normalises, blue chips, with their robust fundamentals and resilience, are well-positioned to weather this period,” said Vaibhav Porwal, co-founder at wealth management company Dezerv.

“In contrast, mid- and small-caps face greater risk of correction due to their higher valuations and sensitivity to economic shifts, making blue chips a balanced choice for both growth and stability,” he said.

Porwal explained that risk-averse investors are increasingly gravitating towards largecap stocks drawn by their appealing valuations, which are closer to historical averages as compared to midcap and smallcap stocks.

Largecap stocks also provide greater stability and are less vulnerable to market corrections, making them a safer bet in the current environment of elevated valuations and global uncertainty, Porwal said.

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The turn of largecaps

The price-to-earnings ratio of Nifty Midcap 100 is 44.19, which is noticeably higher than its five-year average of 37.36,market data show. Similarly, the Nifty Smallcap 250’s PE ratio is 33.89, above its five-year average of 29.05. On the other hand, the Nifty 50’s PE ratio is 23.32, just below its five-year average of 24.68.

Increased trading in smallcap and midcap stocks this year sparked fears of a bubble in the making, considering the relatively riskier nature of such stocks during tough economic times. India’s market experts and regulators are optimistic about the country’s growth prospects but have flagged geopolitical factors including the Russia-Ukraine war and escalating tensions in West Asia as key risks.

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Motilal Oswal’s Shah said while earnings growth for blue-chip companies in the September quarter was 0-1%, midcap and smallcap companies registered earnings growth of 5-7%, adding that while this narrowed the returns gap, the valuation gap persists.

The Nifty 50’s total returns index (Nifty 50 TRI) has expanded at a compound annual growth rate of 16-18% over the previous 4-5 years (barring 2020-21 because of covid), largely in line with the earnings-per-share growth of Nifty companies, said Ramesh Mantri, chief investment officer at WhiteOak Capital Asset Management.

While the returns are above long-term averages they are not outlandish or suggesting any bubble, he added.

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“Small- and midcaps have returned a lot more and markets are usually mean-reverting and relative-value-driven. So purely by rotation, one would expect largecaps to outperform for a while now,” said Mantri.

This can happen either by largecaps giving higher relative appreciation or smallcaps and midcaps declining more in case of any overall market declines, with the same relative result, he explained.

Pockets of value

Aniruddha Sarkar, CIO and portfolio manager at Quest Investment Advisors, said there are both overvalued and reasonably priced stocks across all market segments.

Since corporate earnings are expected to grow at 9-11% over the next year, mid-teen returns from the market should be baked into investor expectations, Sarkar said, suggesting that investors assess companies across various market capitalizations to determine whether their earnings justify their valuations.

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“Good-quality, high-earnings-growth smallcaps and midcaps would give higher returns than blue chip companies. However, the returns might not be linear but would be more volatile,” he said.

The September quarter has been one of the weakest in four years, making valuations appear stretched for many companies across market capitalisations, Sarkar said. However, there are still pockets of good value to be found in all three market caps.