This Ratio Says Smallcaps Are Your Best Bet to Ride the Post Covid Market Rebound

Jun 23, 2020

Richa Agarwal, Research analyst

A few days ago, I wrote to you about the rebound opportunity in 5 Essential stocks.

I must say that it has played out sooner than I expected. These stocks have gained handsomely. Some of them are still in the buying range.

Here's how the broader largecap and smallcap indices have moved.


I am glad to see the markets coming out of the deep fall. But then something about this sharp rebound bothers me.

Like I had warned in my last letter, I believe the rebound could spring a lot of unsuspecting investors, who were waiting on the sidelines, into action. It could make them act rashly.

Rahul Shah, also wrote about this yesterday.

There is another category of investors, preferring stability over anything else. A common query I often get from readers is: Given the volatility and uncertainty, shouldn't we prefer largecaps over smallcaps, to ride the rebound?

I believe it's not a matter of one over the other.

With a careful stock selection, you can invest in both. An ideal portfolio needs a mix of both for optimum returns.

We believe the optimum allocation to be 10% for smallcaps and 55%-60% for largecaps. There will also be variations depending on risk appetite, return expectations, and holding period.

That said, there is indeed something a lot more interesting about the rebound opportunity in smallcaps versus large-caps this time.

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The following table shows the Sensex's reaction to virus outbreaks historically.

Whenever there has been a correction during virus outbreaks, the Sensex has always made a smart comeback.

    Sensex
Virus Outbreak Estimated Period Returns During Outbreak (%) 1 Year Return Post Outbreak (%)
SARS Jan -March 2003 -10 84
Avian Influenza Jan - Aug 2004 -12 50
Ebola Dec 13- Feb 14 1 39
Zika Nov 15- Feb 16 -13 24
Covid -19 March -June 2020 -8 ?
Data Source: Bloomberg, Mint, Equitymaster

But this is an incomplete picture.

Here's what you need to keep in mind.

In the earlier instances, never had the Sensex traded at rich P/E valuation of 25 times, as it did while entering the crisis in March 2020.

Do keep in mind that since 2000, the median P/E for the Sensex has been 19.5 times. At present, the Sensex is at a P/E of 22.5 times. This tells us the market is over-valued at current levels.

Given the rich valuations, I'll not be surprised if post Covid return for Sensex are so not encouraging this time.

The situation is a little different for smallcaps.

I have extended the table to include smallcap index returns during and post virus outbreaks (barring for SARS as there is no data available for smallcap index for that period).

    Sensex Smallcap Index^
Virus Outbreak Estimated Period Returns During Outbreak P/E(Median ~ 19.2x) 1 Year Return Post Outbreak Returns During Outbreak Smallcap to Sensex Ratio (Median ~0.43 ) 1 Year Return Post Outbreak
Avian Influenza Jan - Aug 2004 -12.2 18.0 50 -9.8 0.37 198
Ebola Dec 13- Feb 14 1.6 17.7 39 4.5 0.31 75.6
Zika Nov 15- Feb 16 -13 19.5 24 -15.4 0.44 43.4
Covid -19 March - June 20 -8 22.5 NA -14 0.38 NA
^ Data not available on Smallcap index for SARS outbreak periodReturns are in percentage terms

The smallcap index has outperformed Sensex every time when it comes to returns after the virus outbreak.

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But again, there are some details that should not be overlooked, i.e., the valuations of smallcaps.

Since using P/E for smallcaps is not meaningful, I have used smallcap to Sensex ratio to get a sense of valuations during such times.

The median smallcap to Sensex ratio, in last two decades, is 0.43 times.

In the previous virus outbreaks, whenever this smallcap to Sensex ratio has been lower than the median of 0.43 times, one-year return has been much sharper for smallcaps as compared to largecaps.

It was 198% after the Avian influenza when this ratio was 0.37 times and 75.6% after the Ebola scare when the ratio was 0.31 times.

These numbers compare favourably to 43.4% after the Zika virus outbreak when the ratio was 0.44 times.

At present, smallcap to Sensex ratio is 0.38 times - at a considerable discount to the median of 0.43 times. So, the smallcap rebound is likely to be quite strong and sharper than in largecaps.

But like I have been saying for a long time, you will have to be very selective in picking quality stocks.

So do keep emergency funds aside. Ensure your portfolio is well diversified across asset classes. Do not allocate so much money to a single stock that the loss in that stock could bring down your portfolio's value significantly.

That way, even with a success rate of 3 out of 5 in smallcaps, chances are that you will do well and beat the market.

Warm regards,

Richa Agarwal
Richa Agarwal
Editor, Hidden Treasure
Equitymaster Agora Research Private Limited (Research Analyst)

PS: Join Rahul Shah online at the Rapid Profits Summit on Monday, 29th June. Rahul will tell you about his top 10 stocks to buy in this market. Click here to register for free...

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