Warren Buffett indicator for midcaps and smallcaps signals caution

investors need to be mindful as the outperformance of midcaps and smallcaps over largecaps may start narrowing, especially if they fail to deliver on elevated earnings growth expectations.. (Image source: Pixabay)
investors need to be mindful as the outperformance of midcaps and smallcaps over largecaps may start narrowing, especially if they fail to deliver on elevated earnings growth expectations.. (Image source: Pixabay)

Summary

  • Any negative development on the political front or shifts in interest rate expectations could derail momentum in midcaps and smallcaps and lead to sharp corrections

Midcap and smallcap stocks are garnering a lot of investor attention, thanks to their impressive returns. In this calendar year so far, the Nifty Midcap 100 and the Nifty Smallcap 100 indices have surged 45% and 54%, respectively, significantly beating benchmark Nifty50’s 19% returns. This rally has led to steep valuations.

To gauge the valuation of these stocks, let’s look at legendary investor Warren Buffett’s market capitalisation-to gross domestic product (GDP) ratio. An analysis by ICICI Securities Ltd shows that the market cap-to-GDP ratio for mid and small-cap stocks is at an all-time high as market cap expansion exceeds economic growth.

This ratio is derived by using the total market cap of a country’s listed stocks as the numerator and GDP as the denominator. According to Buffett, it’s "probably the best measure of where valuations stand at any given moment".

There is a concern that after such a massive rally, midcaps and smallcaps might see higher volatility than largecaps. Any negative development on the political front or shifts in interest rate expectations could derail their momentum and lead to sharper corrections than blue chip stocks. That along with frothy valuations warrants increased caution.

 

 

Continued investments from foreign and domestic funds in the Indian equity market, could further boost these stocks. But investors need to be mindful as the outperformance of midcaps and smallcaps over largecaps may start narrowing, especially if they fail to deliver on elevated earnings growth expectations.

Nifty Midcap 100 and Nifty Small Cap 100 are expected to clock 32% and 28% CAGR in profit after tax over FY23-FY25, compared to an 18% CAGR for the Nifty50, according to the ICICI report.

Clearly, with their demanding earnings growth and valuations multiples, midcap and smallcap stocks offer a lower margin of safety compared to largecaps. Even from price-to-earnings (PE) perspective, their valuations seem frothy.

According to Nuvama Research, the one-year forward PE of smallcaps is over 20 times and looks quite stretched compared to long-term average of less than 15 times.

“Given the high mortality rates that smallcaps see (only about 10% of the smallcap become midcap over five-ten year period, the rest remain smallcaps or become micro-caps), we believe that smallcaps are in a vulnerable zone now," the brokerage firm said in a report.

Similarly, the brokerage house cautions against the current 28% premium of midcap valuations over Nifty's which far exceeds the 7-8% average. Thus, further outperformance of midcaps relative to large caps is highly unlikely going ahead.

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