Do Large Cap Funds Make More Sense in An Overheated Equity Market?

January 18, 2024 Mutual Fund

The fascination of investors for mid and smallcaps doesn’t seem to be waning in the Indian equity markets.

The S&P BSE Mid Cap Index Total Return Index and the S&P BSE Small Cap Index Total Return Index, after posting an absolute return of +47.2% and +48.8%, respectively in the calendar year 2023, continue to ascend further.

Graph 1: Midcaps and Smallcaps generated wealth at a faster pace

Index values based on Rs 10,000
Data as of January 15, 2024
Past performance is not an indicator of future returns.
(Source: ACE MF, data collated by PersonalFN Research) 

The largecaps, on the other hand — represented by the S&P BSE 100 -TRI and S&P BSE 30 -TRI — have lagged in terms of wealth creation. In other words, the animated bull market rally since the March 2020 lows of the COVID-19 pandemic has favoured smaller companies.

Investors have been upbeat on the high-beta and high-growth smaller companies, perhaps after tasting much financial success.

But the question is: Will this rally in smaller companies sustain?

The trail P/E ratio (calculated by dividing the Market Value by the Earnings) of the S&P BSE Mid Cap Index is at around 27x, while that of the S&P BSE Small Cap Index is at over 33x (as of January 15, 2024). From a valuation standpoint, these levels for both midcaps and smallcaps do not look inexpensive or reasonable. The margin of safety has narrowed in these market segments. Top of Form

Table: Valuations Across Market Capitalisation Segment

Data as of January 15, 2024
(Source: bseindia.com, PersonalFN Research) 

Whereas, if we look at largecaps — the top-100 companies on a market capitalisation, which are well-established, financially sound, and liquid — on a relative basis, they look fairly valued at the trail P/E of around 25x. Simply put, large and well-established companies are currently offering a better value and margin of safety.

While India may be a land of smallcap investing, — as smaller companies are also participating in India’s economic growth — holding largecaps in your portfolio cannot be overlooked.

At present, the uncertainty around the world has spiked, and risks emanate from…

• Simmering geopolitical tensions (the ongoing Russia-Ukraine war, Israel-Gaza war, the drone attacks on ships in the Red Sea and Indian Ocean, China intensifying its military activity in the South and East China Sea, North Korea test-firing its ballistic missiles, and Russia planning to close ties with North Korea)
• Chances of geoeconomic fragmentation and supply chain disruptions
• Chances of strong or super El Nino weather conditions in 2024, which could affect water availability and food production
• Higher inflation – both food and fuel
• Central banks keeping policy interest rates elevate for longer than expected (which according to World Bank President, Mr Ajay Bagga, may complicate investment across the world)
• Higher borrowing rates potentially slowing down investments
• Tighter financial conditions already exist in the U.S., U.K., some European countries, and China
• Burgeoning debt-to-GDP in many major economies (namely, the U.S., Japan, France, Britain, Brazil, India, and China), which the Institute of International Finance (IIF) expects to increase further
• Chance of global economic slowdown (or a recession) in 2024
• The fact that there are national elections scheduled in India, the U.S., Europe, Mexico, Indonesia, and several other countries (which means there could be some element of political uncertainty and change in dispensation may have a bearing on future economic policies).

The RBI in its latest Financial Stability Report, too taking cognisance of many of these risk factors has warned that the near-term global growth outlook remains tilted to the downside.

If the Indian equity market corrects from its lifetime high, the midcaps and smallcaps may fall more. Amidst the volatility, largecaps may offer better stability to your investment portfolio.

The earnings of largecap companies along with the smaller ones, have been quite encouraging over the last couple of years. Given this and the fact that many companies would participate in India’s growth story, there is a consensus earning upgrade since the last financial year. Currently, the net profit-to-GDP ratio of listed Inc. firms is around 5%. In FY24 and the ensuing years, earnings are expected to improve.

Having said that, it would be unwise to live under the impression that earnings would improve linearly quarter-on-quarter. Particularly when there are ostensible clouds of global economic uncertainty and geopolitical tensions, you ought to be careful.

Going forward, factors such as political stability, fiscal and monetary policies, reforms, income dynamics, inflation, and infrastructure development that define the growth path for the economy would have a bearing on corporate earnings. Earnings are the key to wealth creation in equities.

Graph 2: India’s Marketcap-to-GDP Ratio

For illustration purposes only.
Data as of January 16, 2024.
Source: https://www.gurufocus.com/global-market-valuation.php?country=IND

Indian equities at the moment are commanding a premium vis-a-vis emerging markets and the world. Nevertheless, considering that India is a “bright spot” and promising investment destination, perhaps the premium seems justified.

India’s market capitalisation-to-GDP ratio, famously called the Buffett indicator (named after legendary investor Warren Buffett), after reaching the recent 10-year high of 119.68%, is now at around 96.18% in the ‘fairly valued’ zone.

If you do not have a very high-risk appetite, i.e. are not a very aggressive investor and have a time horizon of around 3 to 5 years, then allocating around a dominant portion – around 60% to 65% of your portfolio to some of the best Large Cap Mutual Funds may prove meaningful.

The five key advantages of owning Large Cap Funds are that…

1. The fund manager makes informed decisions for you, the investor
2. You get exposure to large, well-established companies and financially sound companies
3. Largecaps are highly liquid
4. Potentially offer relatively stable returns and steady growth in the long run with lesser risk (than midcaps and smallcaps)
5. During an economic slowdown, Large Cap Funds tend to witness lower downside risk compared to Mid Cap Funds and Small Cap Funds

Large Cap Funds that follow robust investment processes and systems hold the potential to generate meaningful alpha over the benchmark.

Want to know which are the 4 Best Large Cap Funds for 2024? Watch this video:

Other than Large Cap Funds, you may also consider adding some of the best Value/Contra Funds and Flexi-cap Funds as part of your core equity mutual fund portfolio.

For tactical asset allocation to equity, debt, and gold, a Multi-Asset Fund would also be a meaningful choice now at a market high.

[Read: How a Multi-Asset Fund Can Protect Your Portfolio at a Market High]

Given that the bellwether, S&P BSE Sensex is at a lifetime high (73,402.16 points made on January 15, 2024), to mitigate the risk involved, consider staggering your investments, or even better, take the Systematic Investment Plan (SIP) route if you are planning for vital long-term financial goals, such as your child’s future needs or retirement. The inherent rupee-cost averaging feature of SIPs shall help mitigate the volatility, make timing the market irrelevant, and help remain focused.

The overall returns you clock would hinge on the asset allocation followed, the type of schemes held, and the performance of their underlying portfolios.

[Read: Are You Setting Your Risk-Return Expectations Right While Investing in Mutual Funds?]

Be a thoughtful investor. Avoid following the herd and mindlessly skewing your portfolio to mid and smallcaps.

Happy Investing!

This article first appeared on PersonalFN here