Investors should be cautious of small caps

While the slowdown in the economy hasn’t been as much as expected, smaller-sized firms have been affected more than their larger peers. For this reason alone, small-cap stocks should actually be underperforming...

The Bombay Stock Exchange’s (BSE) Small-Cap Index has risen by 160% from its lows on 9 March. The BSE Mid-Cap Index isn’t far behind, with returns of 144% during the same period. That’s far more than the 105% rise in the BSE Sensex and the 110% rise in the BSE-100 Index.

One would have imagined that investors would be wary about investing in the less liquid mid- and small-cap stocks after last year’s harrowing experience. The mid- and small-cap indices had corrected by 75% and 80%, respectively, from peak to trough, while large-cap indices had corrected around 60%. But with markets across the world doing well and sentiment reviving, the past seems to have been forgotten. What’s more, while the slowdown in the economy hasn’t been as much as expected, smaller-sized firms have been affected more than their larger peers. For this reason alone, small-cap stocks should actually be underperforming.

The fact that the reverse is happening perhaps points to exuberance among so

The fact that the reverse is happening perhaps points to exuberance among some domestic market participants, and it may be time for investors to be cautious about small-cap stocks and perhaps even the markets in general.

At current levels, the BSE Mid-Cap trades at a 16.6% discount to the BSE-100 and the BSE Small-Cap trades at a 23.5% discount. Back in January 2008, when the markets had peaked, the two indices traded at a discount of 6% and 22%, respectively. While mid-cap valuations are better off in comparison, those of small-caps are getting into a dangerous zone last seen during the January 2008 peak.

While there certainly may be small- and mid-cap firms that still offer value, investors need to be beware both of penny stocks and entering into the market at such high valuations.