Microcaps - The Last Bastion Of Relatively Cheap Valuations In A Rising Bull Market: ICICI Securities

ICICI Securities Report

Current microcap universe valuation in terms of trailing earnings yield excluding loss pools is ~6% (trailing price/earning of ~16 times-17 times) as compared to ~4% for large caps (trailing P/E of ~24 times), thereby, offering reasonably cheap valuations in terms of risk spread in a bull market environment.

On the other hand, mid and small cap valuations in terms of earnings yield spread over large caps have diminished significantly with their average trailing earnings yield at ~4.7% (marginally above that for large caps at 4.3%). We have assumed the microcap universe to be consisting of stocks with market cap rank from 501 to 1,000.

Going by the past trends, ‘risk tolerance’ towards microcaps has room for expansion if the current bull market continues. Earlier instances of bull markets in broader equities have seen microcap earnings yield spread over large caps drop to near zero versus current spread of 150-200 basis point.

Assuming that current bull market continues, driven by a broad-based investment cycle, the probability of a repeat of past behavior cannot be ruled out. Mid and small caps, on the other hand, have marginal earnings yield spread over large caps although they too have not reached extreme bull market valuations wherein they trade at a premium to large caps.

Nifty Microcap 250 index has a significantly high weight of ~68% in the broader industrial sector and discretionary consumption, which could benefit from the current demand environment in the economy: Post pandemic recovery, gross domestic product is being driven by growth in ‘gross fixed capital formation’ and higher-end discretionary consumption. GFCF growth has been augmented by the ‘real estate upcycle’ and central government capex while corporates have started showing robust growth FY23 onwards.

Empirical evidence suggests industrials related to manufacturing activity benefit in the aforementioned environment, which is getting further support by the government in terms of policymaking (production linked incentive schemes and overall boost towards manufacturing in India).

NIFTY Microcap 250 index has a large weight in the broader industrial sector (~50%) and discretionary consumption related manufacturing (~18%) as compared to NIFTY50, and given the current trend of economic growth, such stocks are favorably placed in the economic upcycle.

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