Surging domestic liquidity is distorting the valuation metrics between large caps and the broader mid and small caps.
New wisdom seems to have dawned on the Indian equities. “Less is More” is a moving theme now in the mercurial Indian markets. What has intrigued seasoned investors is the emerging divergence in the valuation pecking order. Investors are used to larger caps commanding rich valuations compared to lesser mortals from the small cap space. The rationale for that was simple. Large companies have proven business model, scale, governance practices and management depth. Smaller companies suffered from market’s skepticism on those metrics. But that dictum hardly drives valuations now in Dalal street. Large caps are no longer at a lofty premium to their less fortunate cousins. Multiples in mid and small caps have soared recently to put large cap valuations at a deep discount. On PE valuation basis, much of the large caps are at a large discount to the broader middle and smaller cap space. Below chart captures this trend brilliantly.
Confluence of certain combinations have come together to conspire this bizarre change in the valuation norms in Indian markets. The divergence between FIIs and domestic liquidity is at the root of this growing trend. While FIIs have been on an aggressive selling spree, domestic inflows have surged to new high. Most of the new inflows into domestic mutual funds have been into mid and multi-cap funds. As one estimate puts it, the share of flows into such mid and multi-cap funds is over whopping 80% in the last 12 months. Add to this, the growing trend of return-hungry HNIs shifting money from not-so-rosy real estate to equities. Much of this new money is finding solace in small and mid cap space while FII’s aggressive exits have been largely in the top end. This contrasting behavior has distorted the valuation metrics between large caps and the broader space.
So far it is just fine. Where the story gets scary is in the micro-cap space (below 500cr market caps). Extrapolating the growing trend of out-performance in small and midcap space into micro-caps, many new micro-cap masters have sprouted all over the markets with their new found multibaggers. Micro caps never had it so good. With micro cap investing emerging as a new hot success mantra, the risks have risen manifold.
While some of the froth has been washed away by the ongoing correction, valuations in the broader space remains still high relative to previous cycles. With no let up seen in domestic liquidity ( both from mutual funds and form HNIs), valuations may remain at elevated levels for long in the broader space, thereby limiting opportunities for bottom up stock picking. Hidden gems are no longer hidden. Ironically, for value investors, deep-dive no longer delivers value. It is top-down rather than bottom-up for a while till this distortion lasts.
Happy Value Investing!