There is Still Upside In Mid-Cap & Small-Cap Spaces

Valuation gap is the difference between an entity’s market value and the value at which the seller intends to sell the entity. For stock market indices, it’s the difference between the market price and the Earnings Per Share (EPS). The gap tells us whether the markets have become cheaper or more expensive. Traditionally, large-caps, mid-caps and small-caps are supposed to rally cyclically one after another as they overlap with a demand shift. Thereby valuation helps us to understand who has been outperforming whom. There are parameters which evaluate opportunities to buy the scrips at bargain prices.

Is there any valuation gap?

We have evaluated the valuation of large-caps, mid-caps and small-caps using the indices, BSE Sensex (30), S&P BSE mid-cap (82) and S&P BSE small-cap (765) as the indicators. We have considered the average of ratios of the companies within the indices.

Comparison of broader markets with benchmark

TTM P/E Multiple:

The first of its kind is the price earnings ratio (P/E ratio) that tells how much the investor is willing to pay for the given earnings. The parameter works the best for comparison. Thus we can know the outperformance level of the indices over the benchmark.

We are considering Trailing Twelve Months’ (TTM) PE multiples of various groups like mid, small and Sensex to understand whether there is valuation gap among them. Mid-caps are trading at PE multiple of 38.68x times against PE multiple of 19.84x times. Small-caps are trading at PE multiple of 48.1x times against Sensex PE multiple of 19.84x times. From the indicator TTM P/E multiple, it seems that the mid-caps and small-caps are trading with significant valuation gap from the last couple of years as compared to the benchmark.

TTM P/B multiple:

Price to Book is another indicator wherein the market price is compared with the book value i.e. the net asset value that suggests stability. Lower the P/B, undervalued is the entity and vice-versa.

Now, taking a look at TTM PB multiples of various groups like mid, small and Sensex to understand whether valuation gap exists among them. Mid-caps are trading at PB multiple of 6.21x times against Sensex PB multiple of 2.8x times. Small-caps are trading at PB multiple of 3.96x times against Sensex PE multiple of 2.8x times. While comparing TTM PB multiples of mid and small-caps to benchmark, there is significant gap among them. Indian mid-cap stocks are showing signs of being overvalued, relative to their smaller peers.

When we see historically, mid-cap stocks have outperformed benchmark indices in terms of returns, every time and even after time of year 2009 recession. Meanwhile, small-cap stock pattern is a mixed one and has started outperforming indices from the year 2013.

While taking a first look on the above graph, it appears that there is significant gap between them.

Mid-cap in isolation:

We took S&P mid-cap index companies for working out further valuation basis. This index is trading at 38.68x PE multiple on above average PE multiple of 33.506x times. Historically, PE of mid-caps remained only four times on an its average PE. The mid-caps PE declined in past one year from 45.31x times in 2015 to 38.68x times in 2016. Meanwhile, mid-cap index is increased by 25.02 per cent in last one year. This clearly suggesting that though PE is trading above average, there may be still upside in mid-cap index.

Now, considering PB multiple of mid-cap index is trading at 6.21x times comparing average PB multiple of 5.174x times which is higher. Historically, PB of mid- caps hits all-time high in 2015 and now it is close to that in the year 2016.
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We are now considering another valuation parameter EV/EBITDA to understand is there any gap for the mid-cap index. The EV/EBITDA stood at 37.97x times against average EV/EBITDA of 64.23x times which is quite lower. It is clearly seen that from last five years, EV/EBITDA is trading below its average. Meanwhile, EV/EBITDA of mid-cap increased from 26.2x times in 2015 to 37.97x times in 2016. Lower the EV/EBITDA, it suggests undervaluation. Historically, during 2008 and 2011 mid cap EV/EBITDA was at 230.24x and 209.17x respectively. After that, high EV/EBITDA witnessed sharp fall of mid-caps on bourses.

Small-cap in isolation:

We took small-cap index companies for further valuation basis. This small-cap index is trading at 48.1x PE multiple on above average PE multiple of 30.716x times. From last three years, small-cap’s PE is trading on an above average PE multiple. Meanwhile, small-cap index surged about 17.43 per cent during past one year. This clearly suggests that though PE is trading above its average, there may be still upside in small- cap index.

Small-cap’s PB multiple stood at of 3.96x times is above average PB multiple of 3.494x times in 2016. As far as PB multiple is concerned, small-caps are slightly overvalued. The PB multiple decreased from 4.99x times in 2015 to 3.96x times in 2016.

EV/EBITDA:

The ratio measures the cost of capital that calculates firm’s value in terms of the operating profitability.

Small-cap’s EV/EBITDA remained at 41.29x times which is quite lower as compared to average EV/EBITDA of 51.85x times. This clearly suggests that small-caps are undervalued. So there is still upside in small-caps. Meanwhile, only three times during past 10 years, EV/EBITDA has remained above the normal range.

Few other indicators:

Market capitalisation/revenue:

Usually the price to sales ratio is used to pick up the stocks but for the indices as a whole using mcap to revenues is advisable. A detachment between subjective valuation and the actual performance exists when mcap falls disproportionately to the revenues. The ratio of >1 states that mcap has been inflated, while less than 1 suggests lag in mcap.

Liquidity to valuation:

Conventionally, liquidity and valuations are directly proportional where liquid markets have better performance as measured by market to book ratio. High liquid stocks are supposed to give higher operating returns on assets and a high shareholders’ equity. Tradability of the stock is the most important factor in determining the valuation and performance of the markets. Non-block holder can enter the markets through liquid stocks which results in better trade by informed investors improving the investment decisions.

Conclusion

After studying various valuation ratios, we could see valuation gap is existing amongst the indices. While we say so, we also find that the gap is gradually diminishing where the indicators of the mid-caps and small-caps are tapering downwards while Sensex is more or less stable since 2012-13. We cannot say that any of the indices are over/under valued but at the same time, we do not see any caution (sell-off or avoid signal) for investors for small and mid-caps. The levels of PE, PB and EV/EBITDA are justifiable and there is not any turbulence like situation. So looking at the broader picture we suggest our reader-investors to hold their positions and start accumulating. On the whole, it shouldn’t matter whether the markets are bullish or bearish, every market situation gives you the opportunity to pick the right one-so just get the right stock and sail through.

“If we compare mid cap or small cap with benchmark indices, mid cap are significantly overvalued relative to both small cap and benchmark indices. Mid cap have performed spectacularly this year and the valuation gap between mid cap and small cap is nearly at five year high on basis of price to book. If we compare mid cap with benchmark indices, the valuation premium is more than 60 percent. Hence a caution of degree is warranted when investing in midcaps at this current juncture. In year 2015 too, mid cap and small cap valuation continued to trend higher relative to large caps and this year to the same phenomenon is happening.”

Post the rally in the last two years in the small cap space, the stock prices have run up ahead of the fundamentals thereby factoring in all possible positive up to FY18E-19E and this making valuation justification extremely difficult. Therefore, the broad based valuations in the small cap space are on the higher end. Having said that, we continue to remain selectively positive on some of the pockets where one can find value buys which are reasonable on valuations front, possess good management and hold robust growth potential.