Smallcaps Vs Midcaps - Which is the Bigger Opportunity?

In the aftermath of the pandemic, the stock market was on a roll. Excess liquidity in the market, along with a faster than expected V-shaped recovery fuelled the fire, giving all aspects of the market a much-needed boost.

As a result, from the lows in March 2020, the smallcap index doubled in value by December 2021. The midcap index was also up substantially over that time, rising 1.4x. The BSE Sensex went up 2x during the same period.

But by the end of 2022, things were different. The smallcap index experienced several ups and downs after reaching its peak in January 2022. It is now up only marginally at the end of 2022.

The midcap index reached its record high in October 2022 but has only produced a 4.6% return over the same time.

In comparison, the Sensex is up by 6%, outperforming its smaller peers.

Given that neither index has outperformed the BSE Sensex, is now a good time to invest in the smallcap or midcap space?

Let's find out.

The recent performance of the indices doesn't tell us their fair value. Nor does it indicate whether they are trading at a discount or premium to their historical values.

Enter the smallcap to Sensex ratio and the midcap to Sensex ratio, an effective tool to analyse the attractiveness of these indices.

We examine this ratio by comparing it to the index's historical values. The longer the history, the better it is. It captures the different cycles the broad markets have undergone.

The midcap to BSE Sensex ratio has historically traded at a 20-year average of 0.4x reaching a maximum of 0.52x.

The ratio is currently at 0.42x, indicating that there is room for expansion in the midcap category.

On the other hand, the Smallcap to BSE Sensex ratio has traded at 20-year average of 0.44x with a top of 0.76x.

The ratio is currently at 0.48x, indicating that there is far more room to expand as compared to midcaps.

This makes the smallcap universe a clear winner where opportunity is considered. But, before you go all in, let's take some time to understand the smallcap universe well.

While smallcap stocks offer the prospects of potentially life-changing returns, the outsized returns don't always follow a smooth path.

Small caps can expand more quickly than bigger, more established companies because of their tiny size. Therefore, any policy changes, such as the PLI programmes or higher infrastructure expenditure, can help small enterprises grow much more.

However, the returns are a result of high volatility. Smallcap stocks tend to perform well during market uptrends and underperform when the market struggles.

Therefore, if you are investing in smallcap stocks, you will have to accept the volatility that comes with it.

Moreover, smallcaps are riskier because they don't have the same resources as large corporations. They usually have a lot of debt on their books and lack a long history of operations.

However, the smallcap universe has undergone a sea change. Compared to before, the companies are far more fundamentally sound. They boast strong balance sheets with lower levels of debt and higher levels of cash flows.

This enables them to borrow easily to fund prospective growth and can thus make for a good investment.

But this does not mean, you let go off the margin of safety. Buy a stock trading at a deeper discount to its fair value.

So, on the off chance the business doesn't do well, you have a built-in cushion to absorb the blow. This will help you avoid unnecessary risks and speculative bets in this sector.

Also, limit the downside risks in investing in smallcaps by allocating not more than 10% of your equity portfolio to smallcaps.

This will ensure one's portfolio won't contain any small-cap stocks that make up more than 2-3% of it. Eventually, this allocation will vary from person to person, depending on their financial objectives. Ideally, a risk averse investor should steer clear of smallcaps or limit their exposure to less than 5% of their portfolio.

Similarly, an investor more open to risk, can set aside about 10% of their holdings for smallcaps.

But while you must be cautious, it must not steer you away from investing in smallcaps.

Smallcap businesses are appealing because they have the potential to produce extraordinary returns. This is due to the fact that they are a new and unproven small firm, like undiscovered gold.

Investing in them at an early stage gives you the opportunity to join the company's initial group of investors. Especially before the big boys of the investing community (institutional investors) discover it. Because once unfurled in the market, these equities are re-rated.

They gain popularity, and as a result their prices skyrocket.

A classic example is the chemical company Balaji Amines. The stock didn't come into the limelight until March 2021. But once it did, went from trading at Rs 1,600 per share in January 2021 to Rs 4,000 per share in September 2021, multiplying in a few months.

A smallcap can ultimately transform into a midcap or largecap if the firm does well. A few of the current industry titans, like Bajaj Finance, Titan, and Eicher Motors, were smallcaps fifteen years ago.

The number of smallcap companies on the stock markets is in the thousands, compared to hundreds of mid-cap and large-cap firms. While some are excellent, some are not. Therefore, you must analyse these little businesses, thoroughly.

Don't be frightened to perform extensive study; just do your core homework. Seek out market leaders who are likely to see strong growth.

And lastly, don't compromise on the quality or the competitiveness of the management.

Many small businesses lack the resources to weather tough times financially. And sometimes, they might be mismanaged businesses run by greedy promoters.

Hence it is crucial to do thorough research on the investment in question. This covers the qualifications of the promoters, the management team's experience and success, and both long-term and short-term growth strategies.

Never, under any circumstances - even if the chances are in your favour - give up on research. That is what successful investing is all about.

Happy investing!

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...