Smallcaps likely to fall in next 12-24 months. This indicator suggests so

NEW DELHI: The recent underperformance of smallcaps has taken investors by surprise. But if history holds any clue, more pain is in the offing.

Data showed smallcap valuations are stretched to such a level vis-a-vis Nifty50 that chances of the former underperforming key benchmark indices are quite high in the next 12-24 months.

The smallcap index’s two-year valuation premium (compounded annually) to Nifty50 hit 19 per cent at July-end. This was a level at which the smallcap index has peaked at least on three different occasions since 2007: December 2007, November 2010 and February 18. Will it be different this time?

From a 27 per cent lag in November 2019, the sharp rally now puts the NSE’s smallcap index at a 19 per cent premium (two-year CAGR) to Nifty50, Edelweiss said in a note. “History shows that usually when this happens, the next 12–24 months spell trouble for the smallcap space. Smallcap valuations are also 1.1 times Nifty50’s, while their 10-year average stands at 0.8 times. It is time to be very selective,” it said.

In December 2007, when the NSE smallcap index’s two-year rolling CAGR premium to Nifty50 had crossed 20 per cent, the index declined 71 per cent in a year in absolute terms and 39.9 per cent in two years.

After its valuations hit a similar premium to Nifty50’s in November 2010, the Smallcap index fell 25.7 per cent in the next 12 months and 9.8 per cent in the next 24 months. February 2018 was a similar period where the index declined 29 per cent in a year and 32.1 per cent in two years.

“The past decade-and-a-half shows that relative performance between largecaps and smallcap/midcap indices usually always mean-reverts. Should this repeat, smallcaps’ outperformance to largecaps might well reverse hereon,” Edelweiss said.

This is not the case with midcaps. The midcap index’s two-year CAGR premium to Nifty50 is 8 per cent, while its 10-year average premium stands at 5 per cent, the brokerage said. “We prefer largecaps in the near term. Also, any scale down of retail positions could put pressure on mid/smallcaps. Further, we prefer stocks where the Street has high confidence in EPS estimates,” BofA Securities said in a recent note.

Edelweiss’ study, meanwhile, noted that midcaps might not underperform as badly as smallcaps. It said midcap valuations were less than 1.1 times Nifty valuation, the long-term average.

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