While the small caps outperformed recently, however, on a YTD basis, smallcap index has massively underperformed the Nifty, down 14 percent versus a 1 percent rise in Nifty. In the last 1 year as well, small caps are down nearly 10 percent versus a 0.1 percent rise in Nifty.
Brokerage house Edelweiss Securities believes that the underperformance in smallcap stocks makes a case for a rally going ahead. Bottom 250 (ex-BFSI) stock prices have not outperformed their larger peers while PAT has, it highlighted. Also, small caps (Bottom 250 ex-BFSI and Commodities) were able to increase margins and maintain EBITDA margins maintained by better operational and interest cost management, said the brokerage. Edelweiss expects a catch-up rally in small-caps as valuations remain low.
"Nifty Small Cap Index has given a breakout above the trendline which was active since October 2021 indicating a fresh round of upswing. The valuations on the other hand are at a four-year low. Low valuations and a price breakout make a bullish case for the Small Cap Index," predicted the brokerage.
Edelweiss noted that small caps (Bottom 250 ex-BFSI And Commodities) were able to increase margins both on a YoY And 3-year basis which large and midcap baskets couldn’t.
"Top 100 stocks (Ex-BFSI, Comm.) saw a margin dip of 240 bps on YoY and 50 bps on a 3-year CAGR basis in Q1FY23 to 18.8 percent while the next 150 (Ex-BFSI, Comm.) saw a margin dip of 170 bps on YoY and 270 bps on a 3-year CAGR basis in Q1FY23 to 13.9 percent. However, the bottom 250 stocks (Ex-BFSI, Comm.) were able to maintain and improve margins on both YoY and 3-year CAGR basis despite severe raw material pressures as highlighted earlier," pointed out the brokerage.
The brokerage also revealed that the price performance of Bottom 250 stocks (ex-BFSI) has been largely in line with that of the Top 100 and Next 150 stocks (Ex-BFSI) over the past 3 years, despite the Bottom 250 stocks delivering a PAT growth of 2.32x over June 2019 levels compared to 1.53x/1.2x by the Top 100 and Next 150 stocks (ex-BFSI) respectively.
It further stated that while the raw material (RM) cost increase was much more for the Bottom 250 companies (ex-BFSI and Commodities) resulting in only a 9.5 percent CAGR in gross profit over a 3-year CAGR, the companies delivered exceptional operational cost management to deliver better EBITDA growth compared to the Top 100/Next 150 (ex-BFSI) companies.
Employee and Other expenses grew by only 6.7 percent and 9.1 percent, respectively on a 3-year CAGR for the Bottom 250 companies (ex-BFSI and Commodities) compared to 12.3 percent and 12.2 percent, respectively for the Top 100 and 7 percent and 9.6 percent, respectively for Next 150 respectively resulting in EBITDA growth of 14.8 percent for the Bottom 250 companies on a 3-year CAGR basis, added the brokerage.
It also noted that interest costs also declined the most for the Bottom 250 companies by 5.2 percent while depreciation grew by only 4.5 percent resulting in a huge outperformance in PAT of 33.2 percent CAGR on a 3-year CAGR basis.
Small caps have started seeing a rebound, outperforming benchmark indices since August 2022 despite the recent volatility in the markets on the back of increased risk appetite and excess liquidity. The Nifty Smallcap index gained 5 percent in August and 0.75 percent in September as against a 3.5 percent rise in Nifty in August and 1 percent decline in September.
The recent rebound in the equity markets improved sentiments and the risk appetite of investors leading to a recovery in smallcap stocks. Investor sentiment was improved on the back of a fall in commodity and crude prices and better growth prospects for the Indian economy. Further, positive foreign institutional investor (FII) flows also supported the small-caps.
But it is important to note that small caps are high beta stocks and have considerably higher risks than largecaps and midcaps, this means higher rewards as well when performing well. It can provide a huge opportunity for high-risk investors but are not suitable for risk-averse investors.
As per experts, volatility in the equity market along with sharp earnings downgrades has weighed on the performance of small-caps.
In a report last month, BofA Securities cut earnings estimates for the Nifty Smallcap Index by 7 percent and 1 percent for 2022-23 (FY23) and 2023-24 (FY24), respectively, this year. In comparison, the Nifty Midcap pack saw an earnings upgrade of 5 percent and 8.7 percent for FY23 and FY24, respectively.
Ambit Capital also pointed out that performance analysis of the last decade indicates 1/2 years of relative small-cap underperformance is usually followed by significant outperformance in succeeding years. Given reduced investor risk appetite, it believes that a selective approach through dissecting small-caps on the spectrum of fundamental quality and valuations, to find companies offering “Quality at Reasonable Price” (QARP), could drive alpha whilst managing downside risk.