Large-cap stocks likely to outperform mid and small-caps

Mid and small-cap stocks have been the darling of equity investors for some years now. But the historic trend and the record high valuation of mid and small-cap stocks suggests that equity investors are now better off switching to large-cap stocks

Karan Deo Sharma
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Large-cap stocks likely to outperform mid and small-caps

Large-cap stocks likely to outperform mid and small-caps

Mid and small-cap stocks in India continue to make new highs even as the large-cap stocks struggle to hold their ground. The BSE Mid-cap index is up 17.2 percent since the start of the current calendar year and is up 70.5 percent since the end of December 2022 according to data from the BSE. Similarly, the BSE Small Cap index is up 12.4 percent since the start of the 2024 calendar year and is up 65.8 percent since the end of the 2022 calendar year. 

In comparison, the large cap-oriented BSE Sensex is up just 2.7 percent year to date in the 2024 calendar and has gained 22 percent since the end of the 2022 calendar year. In other words, the mid-cap and small-cap indexes have given nearly 3X the returns of the large-cap stocks.

This is unprecedented given the companies in all three segments operate in the same and are equally affected by the changes in the country's macroeconomics. It’s not that if there is a growth and an earnings slowdown in the economy then mid and small-cap stocks would remain unaffected while large-cap stocks would bear the brunt of it.

If history is any guide, then economic and financial turbulence has a greater impact on small and mid-size firms than their larger counterparts.

The one-way rally in mid and small-cap stocks has led to a sharp rise in the equity valuation of smaller firms and they are trading at a premium to large-cap stocks, which is a surprise. Large-cap stocks have traditionally commanded a valuation premium due to factors like their industry leadership, a bigger and superior balance sheet and the ability to raise capital at a lower cost than smaller firms. The valuation premium of mid and small-cap stocks has turned this argument on its head which doesn't seem plausible.

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The scenario

The 30 large-cap stocks that are part of BSE Sensex are currently trading at a trailing price-to-earnings multiple of 23.8X and a price-to-book value ratio of 3.56X. In comparison, the BSE Mid-cap index is trading at a trailing P/E of 30.7X and a price-to-book value ratio of 3.9X. Similarly, the BSE Small Cap Index is trading at a trailing P/E of 33.5X and a price-to-book value of 3.6X.

Also Read: Five mid and small-cap stocks trading at a deep discount right now

In other words, mid-cap stocks are trading at a 29 percent valuation premium to large caps while small-cap stocks are trading at a valuation premium of 40 percent. This is not sustainable and will see a reversal sooner rather than later. This can be justified only if mid and small-cap stocks could grow their revenue and profits at a faster pace than large-cap companies. But there is no evidence to support this.

If anything, the earnings growth for smaller companies is far more volatile and uncertain than for bigger companies.

Lastly, these three broad segments of the Indian equity market follow a cycle and the out-performance of large-cap stocks is followed by a better show by mid and small-cap stocks after a gap of a few quarters. As the valuation in mid and small-cap stocks get stretched, they begin to underperform and large-cap stocks become rally leaders. And this cycle starts once again. In stock market parlance it is also called segment rotation. (See the chart below)

Large-cap Index Vs Mid-Cap and Small Cap Index. Pic: 30Stades

The historical data suggests that over the long term, they average out and there is no big difference in the returns delivered by large-cap, mid and small-cap stocks. For example, in the last 20 years, BSE Sensex is up 1106 percent compared to a 1315 percent rise in the BSE Mid-cap index and an 1150 percent rally in the BSE Small Cap index. 

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However, when we adjust these headline long-term returns with volatility (or downside risk) in these three indices and add the dividend income, then the Sensex or large-cap stocks have delivered better risk-adjusted returns than mid and small-cap stocks. 

The Sensex companies’ dividend current yield at 1.25 percent is 36 percent higher than the mid-cap index dividend yield (0.92%) and 92 percent higher than the small-cap dividend yield (0.65%).

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. Investors can benefit from this cycle by either investing in large-cap stock directly or they can invest in 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 invest in high-quality large-cap funds that have underperformed by a big margin in the last one year.

(Disclaimer: This article is for information purposes only. Readers are advised to consult a certified financial advisor before making an 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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