{"id":29123,"date":"2024-03-13T15:59:26","date_gmt":"2024-03-13T10:29:26","guid":{"rendered":"https:\/\/fundsindia.com\/blog\/?p=29123"},"modified":"2024-03-13T18:29:11","modified_gmt":"2024-03-13T12:59:11","slug":"are-small-caps-in-a-bubble","status":"publish","type":"post","link":"https:\/\/www.fundsindia.com\/blog\/mf-research\/are-small-caps-in-a-bubble\/29123","title":{"rendered":"Are Small Caps in a Bubble?"},"content":{"rendered":"\n
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This framework was first circulated to FundsIndia clients on 01-Mar-24, as we exited from our Small Cap Tactical call<\/span><\/em><\/p>\n\n\n\n

Are Small caps in a bubble? <\/strong><\/h3>\n\n\n\n

Here is our 6 lens framework (Price Cycle – Long & Short, Valuations, Flows & Sentiments, Earnings Growth Environment, Past Returns) to evaluate where we are in the small cap cycle.<\/p>\n\n\n\n

Instead of taking a unidimensional view, the attempt is to view the small cap cycle from 6 different vantage points to identify the \u2018elephant\u2019!

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What qualifies as a \u2018Bubble\u2019 in small caps? <\/span><\/strong><\/h3>\n\n\n\n

The valuations are so high that even after a 25% correction, it would still remain expensive and doesn\u2019t make sense to enter!<\/strong><\/p>\n\n\n\n

Why 25% correction? <\/strong><\/h4>\n\n\n\n
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6 Lens Framework to Analyse Small Cap Segment<\/span><\/strong><\/h3>\n\n\n\n

LENS 1 – LONG PRICE CYCLE:<\/span>  Long Cycle Indicator is flashing \u2018red\u2019 – close to historical highs<\/span><\/strong><\/h4>\n\n\n\n
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Small Cap Price Cycle –  Current rally at 5.1x times from 2020 lows<\/span><\/strong><\/h5>\n\n\n\n
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Large, Mid & Small Caps tend to converge over long cycles, but small caps do disproportionately well in upcycles and vice versa. Currently, Small Caps have seen a sharp rally of 5.1x from the bottoms in Mar-2020.<\/p>\n\n\n\n

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BSE Small Cap to BSE Sensex ratio close to 16 year highs<\/span><\/strong><\/h5>\n\n\n\n

Historically whenever this ratio has crossed 2.0x the small caps segment has fallen in the short term. Small Cap to Large Cap ratio (currently at 2.3x) has crossed 2018 peak levels and is moving closer to 2008 peaks indicating \u2018high risk\u2019.  This necessitates caution<\/strong> at the current juncture.<\/p>\n\n\n\n

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LENS 2 – SHORT PRICE CYCLE:<\/span> Rally may continue for some more time (6-12 months)<\/span><\/strong><\/h4>\n\n\n\n

In the past cycles, average time from the bottom to peak is ~1.5 to 2 years and average upside is ~2-3x.  <\/strong><\/p>\n\n\n\n

Current rally is at 11 months with 1.8x returns indicating scope for further rally. Using history as a guide, short price cycle indicates that the rally may continue for 6-12 months.<\/span> <\/strong><\/p>\n\n\n\n

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LENS 3 – VALUATIONS:<\/span> Valuations have become \u201cExpensive\u201d <\/span><\/strong><\/h4>\n\n\n\n
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Share of Small Cap Market Capitalisation  in the Overall Market Capitalisation is at higher levels (~17.2%).<\/span><\/strong><\/h5>\n\n\n\n

Whenever the share of Small Cap MCAP in the Overall MCAP crosses 15%, it warrants caution. Currently the share is at 17.2%. The profit share of Small Caps in the Overall Market is still at lower levels (~12%) as compared to the share of Market Cap. <\/p>\n\n\n\n

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Small Caps are currently trading at a significant premium over Large Caps<\/span><\/strong><\/h5>\n\n\n\n

Price to Earnings of Small Cap Indices are trading at historically higher premiums over Large Caps. The current premium of Nifty Small Cap 250 PE vs Nifty 50 PE is at 27%, indicating expensive valuations.<\/p>\n\n\n\n

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LENS 4 – SENTIMENTS & FLOWS –<\/span> Sentiments indicate \u2018Greed\u2019 in the Small Cap space <\/span><\/strong><\/h4>\n\n\n\n

There has been a significant jump in Small Cap inflows and an increasing number of new folios starting May-23. <\/p>\n\n\n\n

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Nifty 100 Trading volume as a % of Nifty 500 has decreased indicating \u2018high risk taking\u2019 sentiments<\/span><\/strong><\/h5>\n\n\n\n
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Google trends show significant Interest in the Small Cap space<\/span><\/strong><\/h5>\n\n\n\n
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Lot of new Small Cap Funds are getting launched and garnering high AUMs despite high valuations indicating high investor interest<\/span><\/strong><\/h5>\n\n\n\n
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List of New Small Cap NFOs launched recently:<\/strong><\/p>\n\n\n\n

  1. Mirae Asset Nifty Smallcap 250 Momentum Quality 100 ETF Fund of Fund (15-Feb-24)<\/li>
  2. Groww Nifty Smallcap 250 Index Fund (09-Feb-24)<\/li>
  3. Bandhan Nifty Small Cap 250 Index Fund (12-Dec-23)<\/li>
  4. Motilal Oswal Small Cap Fund (05-Dec-23)<\/li>
  5. DSP Nifty Smallcap 250 Quality 50 Index fund (05-Dec-23)<\/li>
  6. Quantum Small Cap Fund (16-Oct-23)<\/li>
  7. Baroda BNP Paribas Small Cap Fund (06-Oct-23)<\/li>
  8. Motilal Oswal Nifty Micro Cap 250 Index Fund (15-Jun-23)<\/li><\/ol>\n\n\n\n
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    While on the other side, some cautious Fund Managers have stopped accepting flows in their Small Cap Funds citing concerns on Valuations and Flows<\/span><\/strong><\/h5>\n\n\n\n
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    Mutual Funds regulator SEBI raised concerns over \u201cfroth building up in the Small and Midcap segment\u201d amid continuing flows in these segments.<\/span><\/strong><\/h5>\n\n\n\n

    Industry body Association of Mutual Funds in India (AMFI) in a recent letter (dated 27-Feb-2024) has asked mutual funds to put in place safeguards to protect the interests of all investors in mid- and small-cap funds<\/strong>. AMFI sent this letter after market regulator Securities and Exchange Board of India (SEBI) raised concerns of<\/strong> <\/em><\/strong>\u2018<\/em>froth building up in small and midcap segments\u2019<\/em><\/strong> <\/em>amid continuing flows in mid- and small-cap funds.<\/p>\n\n\n\n

    AMFI has advised mutual funds to take “appropriate and proactive” measures<\/strong> such as moderating inflows, portfolio rebalancing, conducting stress tests <\/strong>on sharp redemption possibility<\/strong> etc to protect investors<\/strong> from first-mover advantage<\/strong> of redeeming investors<\/strong> in case of sharp redemptions<\/strong>.<\/p>\n\n\n\n

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    LENS 5 – PAST PERFORMANCE –<\/span> Flashing \u201cRED\u201d Signal<\/span><\/strong><\/h4>\n\n\n\n
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    Very High Past Performance – 1Y, 3Y, 5Y, 7Y and 10Y annual returns are similar to past Bubble markets  -> Contra Indicator – indicating extreme optimism<\/span><\/strong><\/h5>\n\n\n\n