Small-cap and Mid-cap stocks valuation concerns: Should you invest or avoid?

The small-cap market, which had been steadily climbing, has recently hit a pause due to significant profit-taking and facing the impact of SEBI’s stress test. Over the past year, there was an impressive surge, but now the Nifty Small-cap 100 index has dropped by almost 11.91% since its all-time high, while the Nifty 50 index has seen a 2% drop. The Nifty Mid-cap 100 index also experienced a slight decline of about 6.96% during this time.

The rapid increase in the index’s value raised concerns among investors that the small-cap market might have become overheated and unsustainable. Many anticipated a significant correction, which seems to be happening now. The reason is that SEBI’s accommodating to stress test the small-cap and midcap portfolio of the mutual funds drew down the market and raised concerns about the valuations.

Small-caps and Mid-caps under pressure:

Looking at the valuations of the small-cap 100, it shows that on February 7, 2024, the P/E was at 30.2 and the 1-year median P/E was at 23.6, showing a slightly high valuation but not confirming it. Similarly with Mid-cap 100 stocks where P/E was at 26.1 and the 1-year median P/E was at 23.9, this also looks slightly overvalued but we have to further break this down to conclude whether to invest or avoid small-cap and mid-caps.

One thing investors must understand is that small-caps have higher risk, and financial advisors always emphasize that higher returns are often associated with high-risk assets. So, volatility will always be present in small-cap stocks. The chart of Nifty Small-cap 250 shows the extent of volatility in small-cap stocks which have greater risk of drawdown but offer greater rewards as well.

Should you invest in small-cap and mid-cap stocks?

Stocks are independent of market activities. If you have long-term visions, short-term news or fluctuations should not affect your goal. You must continue to hold the stock until the target is achieved, maintaining patience, and eventually overcoming volatility fears.

Small-caps and mid-caps have surged so high that they have logged around 68% returns for investors. However, it would be unrealistic to expect this trajectory to continue indefinitely. Investors should always bet on companies that are generating earnings for them and which reflect on the price of the stock.

The above tables show that P/E is at the same level where the price has increased and EPS has also increased, indicating that both parameters are in sync and thus the prices are at the right valuations. The price has surged 68% where EPS has also gained 67% in mid-caps and the price of small-caps has surged 68% and EPS has gained 53% which suggests companies are rising with their true valuation and there is no bubble in small-cap and mid-cap.

In conclusion, it doesn’t seem overvaluation in mid-cap and small-cap stocks and individuals can look for potential opportunities in the current ongoing corrections.

Disclaimer: This blog has been written exclusively for educational purposes. The securities mentioned are only examples and not recommendations. The information is based on various secondary sources on the internet and is subject to change. Please consult with a financial expert before making investment decisions.