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Valuation Disparity Between Large, Mid And Small Cap Stocks Create Investment Opportunity

Dalal street Investment Journal | December 5, 2019
Article Intro Image

Market regulator Securities Exchange Board of India defined large cap, mid cap and small cap companies for equity mutual fund schemes on October 6, 2017 in order to have uniformity in the investment objective of mutual funds and eventually help in better comparision of schemes. As per the new definition, top 100 companies in terms of market capitalisation qualify as large cap, companies from 101st to 250th position are classified as mid cap stocks and companies from 251st and onward are classified as small cap stocks.

The new definition has limited fund manager’s choice in stock selection. For example, a large cap fund cannot invest in mid cap or small cap stocks as risk-return ratio is significantly different for all three categories..

Recent spike in large cap stocks have left investors wondering whether there are any good investment opportunities left in the space or it is time to shift focus to mid and small cap universe. In this article, we have tried to analyse valuation disparity between the top 20 and bottom 20 stocks within the large cap, mid cap and small cap universe.. We have sorted the top 500 companies in terms of their market capitalisation.

Price of a stock often reflects expectation of the discounted future cash flows. However, investors also look at two important aspects before making an investment decision: sales growth and return on equity. A company trades at a high valuation multiple if the future cash-ow expectations are higher and the other two parameters are expected to show improvement. In this study, we have used the median values of price to earnings (P/E) multiple, sales growth, stock return and ROE as valuation tools to understand valuation disparity.

Table key parameters

In case of large cap stocks, top 20 and bottom 20 stocks are trading at a median P/E multiple of 24 times and 23 times respectively, which is a negligible difference. To put in simple terms, it means that there is not much variation in P/E multiple and most companies are valued in the similar range. ROE and sales growth of large cap companies is also almost same and hence stock picking has become tough.

Let us now study the mid cap universe. Top 20 stocks are trading at a median P/E multiple of 29 times whereas the bottom 20 stocks are trading at 14 times. However, sales growth and ROE performance of the bottom 20 stocks is close to the top 20 stocks. This means that bottom 20 stocks are undervalued as compared to the top 20 stocks, even though financial performance are not substantially different. Thus mid cap space provide select good buying opportunity for retail investors.

In the small cap universe, difference in P/E multiple is much higher than in the mid cap universe. Top 20 stocks are trading at median P/E of 23 times and bottom 20 stocks are trading at a P/E multiple of 3 times. This is because ROE and sales growth of bottom 20 small cap stocks are much lower compared to top 20 stocks. Thus, bottom 20 stocks in the small cap universe are not comparable to the top 20 stocks. Temporary debt burden and corporate governance issues would have led to subdued financial performance of bottom 20 stocks. There may be some fundamental rerating of these stocks on the cards.

The flight-to-safety syndrome can be clearly observed by studying the stock price return of top 20 and bottom 20 in all the three categories. Investors have preferred safest bets even within the three capitalisations. Highest median stock price return of 19 percent year-onyear by the top 20 large cap stoks indicates that investors have shown preferrence for safety and ignored financial parameters.

Value investors should focus on beaten down but fundamentally strong stocks within the mid cap universe and take advantage of the valuation disparity. Mid cap stocks which are doing well today would qualify to become large cap stocks soon and large cap stocks that are not doing well will be reclassified as mid caps. Thus, a good investment opportunity may be missed if fundamentally strong mid cap stocks are ignored.