It’s time to invest in large-cap stocks and mutual funds

The movement in the broader market in recent weeks suggests that it’s time for equity and mutual fund investors in India to start raising their exposure to large-cap stocks and large-cap-oriented mutual fund schemes. Alongside, they should cut back on small and mid-cap stocks and mutual funds. 

Many analysts and market experts believe that Dalal Street is now ripe for the next cycle of stock rotation which will largely benefit large-cap stocks, unlike the rally in the last six months that favoured mid and small-cap stocks.

The post-pandemic period has been highly lucrative for equity investors especially those that invest in small and mid-cap stocks. The BSE Mid-Cap index is up more than three times in the last three and half years from around 11,800 at the start of May 2020 to 32,300 currently.

The small-cap index has done even better and it is up three and half times during the period rising from 10,900 in May 2020 to close at around 37,500 on Wednesday. In comparison, the benchmark index BSE Sensex, which is a large-cap index, has just about doubled during the period from around 32,500 in May 2020 to around 66,100 on Wednesday.

The performance gap between the three indices is even more glaring in the first nine months of the current calendar year. The BSE Small Index is up 30 percent since January this year against a 9 percent rally in the Sensex while the mid-cap index is up 28 per cent in the period. This is fully reflected in the performance of equity mutual funds. The small and mid-cap funds have outperformed the large-cap and index funds by a big margin in the last 12 months. 

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The market moves in recent weeks however suggest that large-cap stocks are making a comeback after underperforming for many months now.

The BSE Sensex which tracks the market capitalization of India's top 30 large-cap stocks is up 2 per cent month to date in September so far. In contrast, the Small cap index has been almost flat during the period while the BSE Mid-Cap index is up 3 per cent since the start of September. 

Many analysts expect the trend to continue as there is no perceptible difference in the financial performance of large-cap stocks vis-à-vis the mid and small-cap stocks over the longer term. Besides, large-cap stocks are now trading at a valuation discount compared to mid and small-cap stocks. 

For example, BSE Sensex is trading at a trailing 12-month price-to-earnings (P/E) multiple of 24.2X, against BSE Mid-cap index trailing P/E of 25.7X and BSE Small Cap index of 29.5X currently. This has made large-cap stocks and mutual funds more attractive compared to mid and small-cap stocks.

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The three market segments move in a cycle and the next cycle could belong to the large-cap stocks. This will favour the large-cap-oriented diversified equity funds. Another winner could be the index funds that track the Sensex, Nifty 50 or Nifty100 index. The best investment strategy would be to pick good quality large-cap funds that have underperformed by a big margin in the last one-year.

The earnings of mid and small-cap stocks also tend to be highly volatile compared to large-cap stocks.

For example, the combined net profit of stocks that are part of the BSE Small Cap index has turned negative in FY19 and FY21 due to the economic slowdown. Similarly, the combined net profit of BSE Mid-cap stocks had declined by 45 per cent year-on-year in FY21 due to Covid-19, but the combined net profit of BSE Sensex stocks was up by 58 per cent in FY21.

The Indian and the world economy once again faces a growth slowdown and this is expected to have a bigger impact on the earnings of mid and small-cap stocks compared to large-cap stocks. Given this equity investors are advised to now look at large-cap stocks and mutual funds more favourably and cut their exposure to mid and small-cap stocks.

(Disclaimer: This article is for information purpose only. Readers are advised to consult a certified financial advisor before making investment in any of the funds or securities mentioned above.)

(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist). 

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