Introduction:
After the coronavirus impact, all markets across the globe have tumbled – even emerging markets like India were impacted negatively. However, it hasn’t taken much time to recover. Within less than a year, the markets have rallied and touched all-time highs. Now maximum people are confused where they should invest or which category to choose for investing. Yes, there are multiple answers for this particular question, but one of the worthier answers is the Small-cap space.
While talking about the small-cap category, sustainable companies with stable competitive advantages, trading at attractive valuations will produce higher returns over a long-term investment horizon.
Breakdown of small-cap:
After the pandemic, all the stocks rallied regardless of fundamentals; the current rally is a price rally because of the liquidity available in the market. Once the situation comes to normalcy, then again, these fundamentals will cause a bigger impact.
In the small-cap index, there is some correlation between Price and Net profit for the past 10 years. But if we observe, there is strong correlation from 2013 onwards – particularly from 2016 to 2018, the rally was very high.
At present, there is a huge gap between the PAT and Price. So, we could expect that the net profit and revenues will grow in the long-term and that volatility will be high in the short-term.
While coming to the valuations point of view, small caps are trading at fair valuations in comparison to pre-covid market conditions. The average 3 years (2017-19) PE is 33 and the current PE is 56. If we compare the current price to 2019 earnings, the PE is 22. All of us are thinking that the small-cap is overvalued because it’s touched the all-time high. But our comparison with respect to the average 3 years PE (33) and current PE (22) (price/2019earnings) shows we have a huge opportunity.
Data source: ACE equity
In the above chart, we can see the correlation between the Price and Net profit of the index. From 2014-2019, the net profit and the price, both were moving upwards simultaneously. From 2019-20, both the Net profit and Price went down. With this analysis we can conclude that there is some correlation.
Some of the important points in small-cap space that are influential:
- Government has introduced some policies regarding manufacturing
- Due to the Covid impact, companies started saving costs like operational and other costs
- Improved cash flow positions
- Decreasing debt levels
- Improved operating profits
In conclusion, we have the opportunity in the small cap funds based on the past analysis and valuations – this is a great time to invest in small cap funds.
