58% BSE smallcap stocks trading above their 5-year average P/E; is it time to book profit?

Amid selling pressure in the domestic equity markets, small-cap stocks have experienced a notable downturn. While the benchmark BSE Sensex declined by 3.5% from its peak on April 9, 2024, the BSE MidCap and BSE SmallCap indices retreated by 4.8% and 5.3%, respectively, from their respective all-time highs hit on May 3, 2024. Market analysts and commentators are cautious regarding stocks lacking clear earnings visibility.

On the other hand, data shows that almost 58% of BSE SmallCap stocks are trading above their average price-to-earnings (P/E) ratio over the past five years. This indicates that a significant portion of these stocks are currently priced higher relative to their long-term earnings. The P/E ratio is a commonly used metric to evaluate the valuation of a stock.

Sharing his views on the broader markets, G. Chokkalingam, Founder, Equinomics Research, said, “Several pockets of the small-cap segment are extremely overvalued. There is significant scope for further corrections in many small-cap stocks. However, Sensex and Nifty are reasonably valued and they have severely underperformed small and mid-cap segments over the past one to three years. Hence possible corrections would be much limited as compared to small and mid-caps.”

Buoyed by robust inflows by institutional investors, the BSE MidCap and SmallCap indices advanced more than 60% in FY24. On the other hand, the BSE Sensex gained 25% during the same period. Foreign institutional investors poured Rs 2.08 lakh crore into the equity markets between April 2023 and March 2024. On the other hand, domestic institutional investors bought shares worth Rs 2.04 lakh crore during the same period.

Of late, the Securities and Exchange Board of India (Sebi) chairperson, Madhabi Puri Buch in March also raised concerns over stretched valuations of small-and mid-cap stocks.

The data highlighted that several companies, including Aarti Drugs, Alkyl Amines Chemicals, Atul Auto, Arvind, Borosil Renewables, Brigade Enterprises, Caplin Point Laboratories, Carysil, Everest Kanto Cylinder, Force Motors, JBM Auto, Kalyani Steels, and Metro Brands, among others, are currently trading above their five-year price-to-earnings ratios.

Kranthi Bathini, Equity Strategist at WealthMills Securities, commented, “We might observe stock-specific corrections in the small-cap segment. It’s advisable to secure profits in cases where earnings visibility is uncertain. Additionally, investors could reserve some capital to seize more favourable opportunities available at reasonable prices.”

Adding his perspective on the current market conditions, Bathini said that the market is expected to remain within a certain range until the conclusion of the election season. He suggested that greater clarity may emerge following the formation of a new government and the presentation of the full budget.

According to Valcreate Investment Managers, valuations in mid cap and small cap space are no longer comfortable and there are clear signs of froth. “We continue to believe that risk-reward is more favourable in large and mid-caps, relative to small-caps,” the money manager said.