What does Numbers say on Small & Midcap Investing now?

 

There is a huge debate on whether the current correction in small-cap and midcap is an opportunity to invest and make gains from the same. Well, the motive is correct but the expectation or rather aspiration of returns are too high. The valuation landscape for Indian small caps and midcaps in early 2025 presents a mixed picture, balancing between high growth potential and concerns over valuations. Remember every correction is not a buying opportunity and even if it is so one should have revised down return expectation. The valuations of the segments give a clear indication that it is time to stay away since the dust has yet to settle.

 Small Caps:

• Valuations: Small caps in India have been trading at significantly higher valuations compared to historical averages. For example, the Nifty Smallcap 100 index's Price-to-Earnings (P/E) ratio was noted at 33 in early 2025, indicating a premium over its long-term average, which is typically below 15 times.
• Performance: Despite these high valuations, small caps have shown substantial returns, with some stocks experiencing dramatic rises. However, there's a cautionary note on the sustainability of these valuations, with analysts suggesting that not all small caps are at fair value, and many might be overvalued.

 Mid Caps:

• Valuations: Midcap valuations have also been stretched, with the Nifty Midcap 150 index at a P/E of 41.48, far above what's considered reasonable for long-term investment as of January 13, 2025. For the Nifty Midcap 100, the P/E ratio was around 40, indicating that investors are paying a premium for these stocks compared to historical averages.
• Historical Comparison: Historically, midcap valuations have been considered reasonable around the mid-20s or lower for P/E ratios. However, recent data suggests that these valuations are well above this range, with some analysts pointing out that such high P/E ratios could indicate overvaluation or market exuberance
• Performance and Expectations: Midcaps saw a notable performance in 2024, with indices like the Nifty Midcap 100 doubling from January 2023 levels by early 2024. However, this has led to concerns about overvaluation and potential underperformance in 2025 as investors expect a correction or consolidation.

• Earnings Growth: While there's an expectation of moderate earnings growth for small and midcap companies in 2025, the high base from previous years and lofty valuations could lead to market consolidation rather than continued sharp rises.

Now lets get into the Price to Book value analysis.

Small Cap Index

• Nifty Smallcap 100: The P/B ratio for this index has been notably high, reflecting a market where investors are willing to pay a premium for small-cap stocks. As of early 2025, the P/B for the Nifty Smallcap 100 was around 4.49, which is significantly above historical averages where a P/B ratio below 2 is often considered more reasonable for small caps. This high ratio suggests that the market might be pricing in significant future growth or that there's a risk of overvaluation if expectations are not met.

 

Midcap Index:

• Nifty Midcap 100: Similarly, midcaps have shown elevated P/B ratios, with the Nifty Midcap 100 standing at around 4.67 in January 2025. This is also above what might be considered a normal valuation for midcaps, where a P/B between 2 to 3 is often seen as fair value. The high P/B suggests that investors are betting heavily on future growth or are perhaps ignoring traditional valuation metrics in favour of growth narratives.

• Valuation Concerns: Both small-cap and midcap indices are trading at P/B ratios that are above historical norms, which could be a red flag for investors looking for value. However, these valuations might be justified if the companies within these indices continue to grow earnings at a pace that supports such valuations.

In summary, while Indian small and midcap stocks have seen significant growth and offer potential for higher returns, the current valuations suggest a need for caution. Investors are advised to be selective, focusing on companies with solid fundamentals and reasonable valuations amidst the broader market's high expectations and potential for correction. Given these high valuations, investment advice has leaned towards caution, recommending selectivity in choosing midcap stocks, focusing on those with strong fundamentals, growth potential, and perhaps those trading at lower P/E ratios within the midcap universe. Diversification and a long-term investment horizon are also emphasized due to the risk of valuation corrections.

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Time to Reduce Expectation-

 

If you are expecting a return of 25% or 30% from the markets in this CY 2025 or FY -2025-26 will reduce your expectations otherwise your investments will take a major hit. The behavioural aspect of the investors has changed dramatically in the last 4 years when the markets made a way journey and more than that investors were doubling their investments within weeks and months. One of the difficult phases for the Financial advisors will be that investors will have huge return expectations and challenges in making them understand how to ride when the market is volatile.

The 18.5 cr demat account holders came into the Indian markets with the mindset that they want 25 to 30% returns within 3 months and that’s too from their stock selection. The same expectation has been built on the Mutual Fund side too where short-term returns of around 20% could be made in 6 months. SIP gross numbers also grown in the last 4 years SIP were positive and were showing healthy returns.  The IPO market was a stellar performer in CY 2024 and people bet their funds without knowing much about the companies and just chasing short term. The most surprising part is that out of these 18.5 cr demat account holders, 90% are focussed and believe that Micro Cap, small will make more money rather large cap and midcaps. Well, these investors are bound to take a massive hit so as their financial advisors called Equity Dealers.  

The biggest battle for the investors and financial advisors is re-alignment towards the expectation of the return compared to what they achieved in the last 4 years. The below chart speaks loudly about how the behavioural aspect of the investors will be challenging for investing. In many places, investors have created liabilities based on the flow of income from the capital market based on the short-term returns being generated. This is another place where a blow is yet to be discovered.

Many investors are under the hope that the recent correction in small caps and micro caps is an opportunity to buy. Well, the opportunity exists but not the return expectation married with the historical time frame. That is the lag where investors and both advisors will get stuck. Valuations coming down and stock prices looking cheap is always an opportunity for investing for creating long-term wealth but does that match with the expectation for returns compared to what we all got in the last 4 years? This is a wide gap.

•  Nifty Midcap 150: Strong performance in YTD 2024 (24.5%) and 1Y Return (23.8%), showing resilience even in December 2024 (1.12% gain).
• Nifty Midcap150 Momentum 50: Outperformed in YTD returns at 32.3%, with a strong 1Y Return of 31.6%. Momentum strategies in midcaps have clearly been beneficial.
• Nifty Smallcap 100 and Nifty Alpha 50: Posted strong YTD returns of 24.9% and 33.9%, respectively, reflecting robust performance in smallcap and alpha strategies.

Smallcap Focus:

• Nifty Smallcap 250: Moderate gains in December (0.20%), but solid YTD return of 27.2% and 1Y Return of 26.4%, showcasing a favourable environment for smallcap investments.
• Nifty Smallcap250 Quality 50: Quality-focused smallcaps delivered YTD 27.5%, maintaining a steady 1Y Return (26.5%).

In 2024 we found Nifty Next 50 and High Beta and other segments where Investors have deep trust and moved ahead to make wealth.

•  Nifty Next 50: Among the biggest laggards in December (-3.80%), despite a strong YTD return of 28.4% and 1Y return of 28.2%. This discrepancy might indicate short-term pressures in December 2024.
• Nifty 50: Declined 2.02% in December, with YTD and 1Y returns of 10.1% and 10.0%, respectively—highlighting its defensive nature but underwhelming compared to midcaps and small-caps.
• Nifty High Beta 50: Affected heavily by December's 4.76% decline, leading to a 1Y Return of just 4.3%, demonstrating its sensitivity to market volatility.

Among all these havoc and volatility one segment that went truly winner due to its structural segment was Momentum and Alpha Factors.

• Momentum strategies like Nifty Midcap150 Momentum 50 (32.3% YTD) and Nifty500 Momentum 50 (27.2% YTD) were clear winners.
• Alpha strategies (e.g., Nifty Alpha 50) delivered robust results (33.9% YTD, 27.6% 1Y Return).

Wealth advisors have also chased PMS and AIF investments and unlisted shares along the same lines.  5 years funds were exited within 2 years and wild goose churning was part of the practice of the wealth advisors. Now that era is also over.

Now comes the biggest question how much return is expected from the market in CY 2025 or FY-2025-26? Bring down your expectation and match it with the last 20 years' return of the markets and one can expect 200 to 300 bps more over and above that return. We need to understand that we are not chasing valuations, price fall, or quality improvements. We are chasing 25% to 30% returns in months, quarters or even weeks.

Do you when the SIP net number will decline and gross the numbers too? Once you witness the SIP getting into negative returns. The irony of all investments made during the last 4 years has been the return and tenure and have nothing to do with valuations or asset class or within  asset class equity segments.

What actions did Mr Trump take, well he only knows but currently, import prices for India have gone up and export markets are awaiting for shift in supply chain conditions to be created by a tariff war. Financial Influencers also need to bring down the expectations of the investors since they have played a tremendous role in growing the greed and converting the behavioural aspect of investors.

The biggest pain every financial advisor will face along with investors is to re-adjust and re-align with the expectation of the return and that is a trap that every investor under the disguise of falling prices and declining valuations will get into.

It is time to calm down on return expectations and stop chasing the wild goose.

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