Mid & Small Cap Valuations: Opportunity or Trap?

Is this a good time to buy mid and small caps? Prima facie, it does appear so.

Both the BSE Mid Cap and Small Cap indices are down anywhere between 20-21% from their 52-week highs. In other words, they are officially in a bear market, technically defined as a fall of 20% from the top.

In fact, if the indices are down so much, I am sure a lot of the stocks in these two indices are down much more.

So, should we just go ahead and grab fundamentally strong companies among this bunch of big losers and then wait for the prices to go back up? Or is there more pain in the offing?

To be honest, grabbing stocks on the basis of their significant fall from the top may not be the right thing to do. Valuations also need to be taken into account.

And this is where our number crunching may come in handy. You see, out of the 360 odd mid and smallcaps that we have data for, nearly half of the stocks are trading at a discount to their 10-year average PE ratio.

This means that if 10 mid/small caps had an average PE ratio of 25 over the last 10 years, then 5 of them are now trading at a PE ratio of below 25 times their trailing twelve-month earnings.

We performed a similar analysis using the price to book value or PB ratio and got the same result. Around 5 out of every 10 stocks are trading at a discount to their average PB ratio of the last 10 years.

To put things in perspective, this number was just 20-30% back in September 2024 when the indices had scaled new lifetime highs. So, from around 3 out of every 10 stocks being attractive, from a valuation standpoint, the number has now gone up to 5 out of every 10.

Therefore, valuations are definitely attractive to what they were a few months ago in September 2024.

Well, here's the interesting bit. Do you know what were the valuations like in March 2020 when the markets had crashed due to the Coronavirus pandemic? For lack of a better word, the valuations were mouthwatering back then.

Nearly 8 out of 10 mid and small caps were trading below their long-term valuations. It was a free for all to be honest. It was one of the best times in recent years to hop on to the mid and small cap bandwagon and rake in the moolah. And those who did, certainly raked it in.

The million-dollar question now is should we wait for similar valuations to show up again or was 2020 a once-in-a-lifetime event that may not happen anytime soon?

In all honesty, the answer will depend on the kind of investor you are and the kind of investing framework you follow.

If you are a defensive investor who's happy earning market like returns over the long term or are willing to invest with a fund manager, then a systematic investment plan with an investment horizon of at least 7-10 years is one of the best options for you. More so, if you have started your SIP only recently.

So, stay the course and have a long-term orientation.

On the other hand, if you are an aggressive investor who wants to outperform the benchmark indices then you should certainly take the road less travelled and try and outsmart the crowd.

You can do this by toggling your allocation between stocks and bonds and also look to be fearful when others are greedy and vice versa.

So, you can start with having a 25% allocation each to stocks and bonds and invest the remaining 50% in either stocks or bonds based on the broader market valuation.

I am tempted to keep 50% in each of the asset classes right now and increase the allocation to stocks should the markets fall further.

However, if they were to rise from here, I will have to reduce stock exposure and have more in bonds.

This strategy fights an investor's natural tendency to put money into stocks after they have gone up and take money out after they have fallen.

Hence, design your strategy in such a way that you put more money into stocks after they have gone down and reduce stock exposure after they have gone up.

Will this strategy guarantee outperformance?

Well, there's no strategy that can promise outperformance. Buying good quality stocks at attractive valuations and toggling between stocks and bonds the right way, can put you in a good position to earn market beating returns over a period of 3-5 years.

Hence, if you find yourself with some spare cash right now and you are itching to take fresh stock exposure, then you are indeed on the right track.

Happy Investing.

Warm regards,


Rahul Shah
Editor and Research Analyst, Profit Hunter
Equitymaster Research Private Limited (formerly Equitymaster Agora Research Private Limited) (Research Analyst)