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A study conducted by Capitalmind Financial Services shows that there could be a correction in small cap index as earnings in small cap index haven’t grown in line with the price, which has led to high valuations of many small cap stocks.
The report shows that P/E ratio of Smallcap250 index has expanded more than earnings per share (EPS) of Smallcap 250 in between July 11,2023 to July,11 2024. The P/E of Smallcap 250 grew by 63%, whereas earnings per share (EPS) was flat at -3%.
The report also talks about the ideal P/E ratios for better returns, which is below 20 to 30. This was depicted by data from December 1, 2017 to 11 July 2024 that infers median 6 months returns is best when the PE ratio is below 20. The median 6 months returns turns negative as the PE ratio moves upwards of 30. The worst median 6 months returns are in the PE ratio range of 35-40.
So, going with the above figures, over the last four years, during July 2020 to July 2024, the percentage of stocks with PE less than 30 has reduced from 76% to 37%, whereas the PE range between 30 to 50 has increased from 13% in July 2020 to 29% in July 2024 and PE range of more than 50 has moved up from 11% to 33% which can lead to poor returns in this segment.
The Capitalmind Financial Services study also advises investors to not over allocate in small caps; instead keep a diversified portfolio. If one wants to go ahead with small cap funds then they should be stock specific instead of going with index.
