The upcoming March quarter earnings season is set to be a litmus test for smallcap companies as they will need to justify their premium valuations amid continued exuberance in their stock performances. After stellar 60% gains in FY24, the S&P BSE Smallcap index has continued its bull run in the first few trading sessions of FY25 notwithstanding the valuation worries.
The smallcap index has already risen over 6% in 4 trading sessions this fiscal year, more than recovering the 4.6% losses seen in March, which was its worst month in around 2 years. The correction in March followed the comments from Securities and Exchange Board of India’s (Sebi) chairperson Madhabi Puri Buch about the build-up of froth in the broader market.
According to the BSE data, the smallcap index is currently trading at a price-to-earnings multiple of 32 times its trailing 12-month earnings, which is significantly higher compared to its historical average PE multiple of 18 seen in the last nine years.
However, that is not the case with the BSE Midcap index. The index is trading at PE multiple of 28 times its trailing 12-month earnings, which according to the data, is lower than its historical average PE multiple of 37.5.
PGIM India Mutual Fund said the valuations in the broader market are running ahead of fundamentals. The fund house highlighted that while the smallcap indices have seen sharp returns in FY24, the aggregate profit growth of the Nifty Smallcap 250 index companies has been 25% in the first three quarters of the year.
Market participants said the pace of earnings growth of smallcap companies may need to accelerate if these valuations were to be justified in the longer run. “The companies will have to deliver topline and bottomline growth. The valuations have run-up, and now their earnings growth will have to catch up,” said Deepak Jasani, head of retail research at HDFC Securities.
Several fund managers highlighted that relatively lower analyst coverage of smallcap companies was one of the reasons for significant mismatch in market value and fair value of these companies. This makes investments in such companies prone to surprise swings, the market participants said.
Smallcap companies have seen significant inflows from domestic retail investors over the last couple of years as a result of post-pandemic changes in savings and investment trends. The money has flown in from both direct investments as well as mutual fund schemes.
“You cannot expect valuations to be cheap when you are collecting 20,000 crore rupees by way of monthly SIP and your economy is growing at 7.5%,” said Deven Choksey, MD of KRChoksey Shares & Securities.