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Mini Ratna - Portfolio of Smallcaps with the Potential to Become Future Midcaps & Largecaps

The massive correction in Smallcaps was triggered by corporate governance issues including related party transactions, fraudulent accounting practices and last but not the least over-valuation in smallcap stocks. The Price/Earnings multiple of Smallcap index at the peak in January 2018 was trading at an expensive 114 times. However, the market cap of bottom of the pyramid (i.e 501-1109) Smallcap stocks have corrected by a massive 67% from January 2018 to December 2019. Given the correction, valuations of Smallcap companies are trading at very attractive levels. However not every Smallcap stock will be a winner. Only quality stocks having visionary promoters and following good corporate governance practices will be the winners of tomorrow. Our research team has found these winners in our Mini Ratnas.

Why Should you Invest in this Portfolio...

Massive Erosion in Marketcap of Smallcap Stocks

Timing is one of the main factors for earning handsome returns in Smallcap stocks. Given that timing is crucial, what is the best time to invest in Smallcaps?

It is when pessimism in these stocks is at its peak.

With a fair amount of confidence, we conclude that the pessimism in these stocks have reached a peak given the deep correction stocks prices have been through. Market capitalization of Smallcap companies as highlighted in red has seen correction to the tune of 38.3% and 66.6% respectively since January 2018. This is in contrast to top 25 Nifty companies which witnessed a positive move of 28%.

Segregation of Listed Companies as Per Latest Market Cap Market Cap as on 31 December 2019 (in cr) Market Cap as on 15 January 2018 (in cr) Change in Market Capitalization Median Price/Earnings (PE)
1-25 7392224 5765494 28.2% 228.2
26-50 2065873 2011840 2.7% 32.5
51-100 1964240 2180572 -9.9% 30.0
101-250 2297754 2672909 -14.0% 24.3
251-500 915463 1482798 -38.3% 19.9
501-1109 330292 987616 -66.6% 11.5
Source: ACE Equity

These smallcaps are trading at a very attractive valuation owing to such a deep correction. Median price/earnings (PE) ratio of these companies is trading at a huge discount to largecaps as seen in the table.

A Ratio you Cannot Ignore

This ratio is Smallcap Index to Sensex Ratio. To simplify, if Smallcap Index is trading at 7000 and Sensex is trading at 35000, then Smallcap Index to Sensex Ratio stands at (7000/35000)= 0.2.

We studied how this ratio has moved since 2003. And the most important number to keep in mind is 0.3. Everytime this ratio has moved to 0.3 as seen in the chart below, there is a huge up-move in the Smallcap index.

ACE Equity

Source: ACE Equity

The first time it happened in 2003 – the index jumped by 219%. The second time it happened in 2009 – the index jumped by 249%.The third time it happened in 2013 – the index jumped by 224%.

Now the ratio has once again touched this Rebound Line. And there is a possibility of the index to rebound massively from current levels.

In a Rare Instance, Midcap Index Valuations Trading below Nifty Valuations

Price/ Earnings valuation of Midcap and Smallcap indices either trade at a discount or premium to Nifty index. To simplify, if Nifty trades at a price/earnings multiple of 30x and Midcap index trades at 28x, then we conclude that Midcap Index is trading at a discount to Nifty Index by (28x-30x)= - 2x. In the similar example,wherein Midcap index trades at 33x, then Midcap Index is trading at a premium to Nifty Index by (33x-30x)= + 3x.

Historically, Midcap and Smallcap index have traded at a premium to Nifty Index. However, given the massive correction seem since January 2018, valuation premium has now converted to discount as circled in the chart. A similar phenomena also happened in June 2015 as see in the chart.

Midcap Nifty

It’s interesting to see how Midcap & Smallcap index recovered since June 2015 given the attractive valuations.

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Midcap and Smallcap index moved higher by 67% & 77% higher in a span of just two and a half years. Given that valuations again are trading at a discount, there could be a similar up-move in the indices.

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