Valuation disparity broadens even as Sensex, Nifty hit all-time highs

Median P/E multiple of top 100 companies by market value is nearly 30 times their trailing 12-month earnings

The valuation differential in the market is widening as benchmark indices touch new highs. The median price-to-earnings multiple (P/E) of the top 100 companies by market value is nearly 30 times their trailing 12-month earnings. At the same time, that of the bottom 100 is less than nine times. 

Market players said the general weakness in the market, as well as the Securities and Exchange Board of India’s (Sebi’s) fund re-categorisation and reclassification norms, have led to disproportionate flows to the top 100 companies.

The battering of mid- and small-cap stocks, given their debt and corporate governance issues, has prompted investors to park their funds in select large-cap stocks. This has driven up stock prices and valuations of large-caps. Since the beginning of 2019, the BSE Largecap has risen 9.5 per cent while the BSE Midcap fell 3.7 per cent, and the small-cap index went down 8.8 per cent.

Analysts said the general pessimism regarding the mid- and small-cap segments led to selling pressure, even in quality stocks. “People today are thinking about a flight to safety and how not to lose money, rather than make significant returns in the next two-three years. And, it happens during every downturn. The only difference this time is that the Sebi’s regulations partly triggered it,” said Samit Vartak, chief investment officer and partner, Sage One Investment Advisors.

Analysts said till small- and mid-caps start giving returns similar to large-caps, new money coming to smaller companies is bleak. They say huge structural changes are required for the valuation parity to kick in.

“For the situation to improve, we need a faster and hassle-free takeover process and lesser protection to incumbent managements. And small- and mid-cap companies should improve capital allocation decisions, including higher payouts in the form of dividend or buybacks,” said Deepak Jasani, head of retail research, HDFC Securities.

Sebi’s reclassification exercise, which came into effect from July 2017, resulted in an outflow from mid- and small-cap stocks to large-caps. According to Sebi norms, large-cap funds could invest in the top 100 stocks in terms of market capitalisation, mid-cap funds can invest in the top 101-250 stocks, and small-caps can invest in stocks ranked from 251. 

The new norms led to buying being concentrated upwards, leading P/E and P/BV expansion for the top 100 stocks.

Analysts said, ideally, investors should not differentiate stocks based on the market cap and base their investment decisions on a company’s fundamentals. For example, a company, which is a leader in a small industry, will not be a large-cap because of the size of the sector. However, it will have a similar competitive advantage as a leader in a large sector.  

Market players said that Sebi should make its reclassification norms a bit more flexible. It must put some restriction on the average market cap of firms, instead of classifying the top 100 companies as large-caps, they felt.

“Maintaining certain risk metrics of the portfolio, such as liquidity and weighted average market cap, may be considered by the regulator. This will provide more flexibility to the fund manager without compromising on the risk profile of the portfolio,” said Vartak.