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The BSE Sensex is down by about 8% in the year to date (YTD). For the same period, the Mid Cap and Small Cap indices gained 2.3% and 0.8% respectively. This means that mid and small cap stocks have outperformed their larger peers during this period.
So...the key question remains...should you continue to invest in such mid and small sized companies?
Going simply by history, during times of market boom, it will be the mid and small cap indices that outperform. However, during times of tepid economic growth, these very companies are first to get hit and thus do not do well. Not to mention the other issues that prop up - such as liquidity issues (in terms of their trading volumes). This makes it difficult to exit positions - more so for institutions however. This is another reason why the smaller companies' stocks take a hefty beating on the bourses.
Coming to valuations, the Price to Earnings (PE) ratio of the BSE-Mid Cap index stands at 25.12x versus 19.97x for the BSE-Sensex. This premium valuation for the former is amongst the highest in the preceding two years. As reported by the Business Standard, valuations of stocks such as Strides Arcolab have jumped from five to fifty-three times since the beginning of the year. Further, stocks such as Aurobindo Pharma, Marico and Shree Cements have also shot up by 15% to 40% on a YTD basis.
Do such types of stocks continue to remain attractive at the current valuations?
We at Equitymaster believe in the bottom up approach in investing. This approach de-emphasizes the significance of economic and market cycles. The approach focuses on the analyses of the individual stocks.
One certainly should not mind paying a high PE multiple for a stock with great growth visibility. However, the key is that the growth needed to justify the high valuations would certainly need to be higher than capability (in most cases at least). Investors would rather pass up such opportunities, than putting their capital at risk.
Midcap and smallcap stocks have the potential for big returns no doubt. However one should be cautious to get into the stocks looking at their earnings growth potential and valuations.
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