Smallcap, midcap stocks: Why 2 years of rangebound trading do not imply 'cheap valuations'

The median correction in small and midcap (SMID) stocks, along with two years of rangebound SMID index, is similar to past downturns, but valuations remain expensive across parameters. Nuvama said a truce on the Iran war front may trigger a relief rally, similar to the one seen last year following the postponement of Trump tariffs, but a breakout may still not be on the cards. The domestic brokerage expected SMIDs to remain rangebound until fresh stimulus arrives or valuations turn attractive, concluding that a price or time correction does not necessarily imply cheap valuations.

The BSE Small and Midcap 400 Index  peaked in September 2024. While it did correct 8 per cent from its record high of 13,045.31, the index has been stuck in a very narrow range. of 11,000 to 13,000 levels for the last two years. 

Absolute valuations
It said SMIDs trade at 4 times price to book value, a 20 per cent premium over the 10-year average and two times bottom cycle valuation (1.5–2 times). Historically, it said five-year SMID returns have
been subpar from such valuations. While balance sheets are certainly in a better shape, but we doubt “this time is different” as growth too is lower, Nuvama said.

"Further, apart from PB, SMID valuations are high both relative to GDP as well as earnings. Thus, essentially absolute valuations are still far from fair value zone. A sustained bottom is made when valuations undershoot and not at fair value," Nuvama said. 

Relative valuations
Even relative to Nifty or global peers Indian, SMID valuations remain quite high compared to its historical averages. At present SMIDs trade at 40 per cent premium over Nifty against a long-term average of 20 per cent. They traded at 40 per cent premium over US smallcap and midcap. This is despite low growth differential.
Typically, SMIDs trade at a discount when growth differential is subdued, Nuvama said.

Relative to growth rate
SMIDs earnings yield at 3 per cent lower than India’s bond yield, a historic discount which can be justified only by a very strong growth. However, growth has been weak, with one-year forward EPS flat lining for two years. 

"During downturns, growth is typically missing and hence rate support needs to cushion valuations. On that front as well, SMIDs are on the higher side with earnings yield of just 4 per cent, while a bond yield is of 7 per cent. This is at a time when SMID 1Y forward EPS growth has been flat (as downgrades overwhelm upgrade from rollovers). This is a historical anomaly," Nuvama said.

Trailing returns
Nuvama said SMID valuations are nowhere close to bottom cycle levels. "Today, while SMIDs have been flat for two years, they are essentially coming on the back of a very high base. Typically, a sustained bull run in SMIDs occur when 3Y and 5Y rolling CAGR turns flat to negative. Today, they are in high teens. To reach the milestone, SMIDs will either need time for correction or another couple of years of outright price correction," Nuvama said.

Earnings missing
Will SMID earnings rebound sharply, a la 2020, 2022 post supply shock? Nuvama said consensus is forecasting V-shaped SMID earnings rebound with 22 per cent profit CAGR in FY26–28. Supply shock normalisation should certainly help. "But sharp rebound a la Covid-19 (2020) or the Russia-Ukraine war (2022) is unlikely as large global stimulus (a la 2020), unlocking pent-up demand (a la 2022) is missing," it said.

Conclusion
Essentially, Nuvama concluded, correction over the last two years has not materially diminished SMID valuations. It said investors should brace for a longer period of correction unless rates drop sharply or earnings revive in a V-shaped manner.