Is this the right time to bet on India’s Small Cap stocks?

The stock market has been nothing but a roller coaster ride since the last few weeks. In a spur of the moment it goes up like a rocket and the next moment it trembles and falls like the wealth of Vijay Mallya. We keep hearing from the millennial investors to “Buy the Dip!” but no one tells when the real dip is and what stocks exactly to buy!

Now, after watching “Scam 1992” we all have enlightened ourselves with the fact that Large-Cap stocks add to the stability in our portfolio since they are less volatile but to generate exemplary returns we need to have Small-Caps in our portfolio too. But this brings us back to our original question – Is this the right time to bet on India’s small cap stocks?

The Nifty 100 Smallcap index has dropped by more than 31 percent after hitting a record high in January 2022 as concerns over sky-high valuations, rising interest rates, high inflation and slowing earnings growth weighed on sentiment. Infact, India’s Small-Cap stocks have not been this cheap since July 2020.

This decline, however, has also resulted in an even sharper compression in valuations of the Small-Cap stocks this year. According to Bloomberg data, the one-year forward PE of the Nifty Smallcap 100 index has shrunk more than 51 percent from its peak of 28.53 times in March 2021 to around 14 times currently, thus representing a huge buying opportunity if a stock with a good business outlook is chosen. Not only this but currently, the Nifty Smallcap 100 index is trading at a more than 20 percent discount to the Nifty in terms of one-year forward PE ratio.

It has been further noticed in the past that a discount of more than 20 percent between the valuations of the two indices has been a catalyst for a bullish turnaround for small-caps, leading to a narrowing of discount and we are at the current stage of reversal.

Such markets present an opportunity for long-term investors to buy as the companies are available at such reasonable valuations. One can say that the risk-reward ratio has become favorable for long-term investors in India at the current stage. However discount in valuations should not be viewed in isolation and investors should look at companies generating cash flows with a healthy balance sheet and available at reasonable valuations.

However, some analysts believe that the small-cap space may not see a quick revival given investors’ risk appetite has shrunk following a gruelling bear market over the past four months and argue that the revival will come with the Nifty turning around and not the other way around.

Regardless of all such situations, the retail investors have been buying the dip and this can be gauged from the upturn in inflows for small-cap mutual fund schemes. The data from the Association of Mutual Funds in India shows that the average monthly inflow into small-cap equity funds in the first five months of 2022 has risen 364 percent to Rs 1,621 crore compared to the last five months of 2021.