Is the sleeping giant stirring?

We recently discussed why investors should keep an eye out for the very largest companies in India.

In this post, we’ll look at some technical reasons why the overall large-cap space might potentially see an uptick in the near future.

Take a look at the graph below, which plots the price ratios of the BSE SmallCap and BSE MidCap indices against the Sensex, which is a large-cap index.

Source: Bloomberg; DSP. Data as of July 2024.

The more-or-less cyclical nature of these ratios should be evident from the graph. We can see that when these ratios are relatively high, large-caps are preferable.

Now, post-COVID, SMID indices have consistently outperformed large-cap indices. The BSE MidCap index is now trading at its highest level relative to the Sensex, while the BSE SmallCap index is just shy of its 2005 record.

This outperformance also means that the SMID space is currently at a relatively expensive level, which might make large-caps more favourable at this point. This is also borne out by the graph below: the 12-month relative rate of change of SMID indices compared to the Sensex (a measure of how much SMID indices have grown over a 12-month period compared to the Sensex) seems to have begun to decline, suggesting that we might be approaching a period of reversion to the mean (i.e. a decrease in relative SMID outperformance, or even a period of relative underperformance).

Source: Bloomberg; DSP. Data as of July 2024. ROC – Rate of Change

This indicates that it might be a good time to invest in large-cap indices. While it’s true that valuations are currently above average or expensive across the Indian equities market, valuations for large-caps are still relatively favourable at this point.

Moreover, in light of the above, if you still wish to invest in small- and mid-cap (SMID) stocks, it might be best to do so through incremental SIPs.

What would Buffett do?

Here’s one more thing to consider. Over the last five years, large-caps posted a CAGR of 19%, while small-caps and mid-caps posted CAGRs of 33% and 29% respectively¹.  The large inflows that the SMID space has been seeing are a consequence of its performance over the last few years.

Flows follow returns; flows don’t cause returns.

Currently, the large-cap space is somewhat starved of investment flows. It could be argued that investors are either pessimistic or outright fearful of the relatively lower potential of large-caps, and overly enthusiastic about the prospects of SMID stocks.

This brings a famous Warren Buffett quote to mind:

“Be fearful when others are greedy, and greedy when others are fearful.”

So it’s possible that the current pessimism surrounding large-caps actually makes them more worthy of consideration right now!

For more actionable insights backed by data and analyses, we invite you to read the latest edition of Netra in its entirety.

¹ Source: AMFI, DSP.