Since July 2020, India's small-cap stocks have not been this affordable

Some market participants think there is a rationale for investors to take another look at the sector after the small-cap index of the National Stock Exchange fell by 31%.

After reaching a record high in January, the Nifty Smallcap 100 index has dropped more than 30% as worries about valuations, increasing interest rates, high inflation, and slowing profits growth dampened optimism.

Small-cap stocks have so far capitulated in a manner consistent with prior bear markets, with the sector losing an average of more than 30% from its most recent peak. However, the fall has also caused small-cap stock prices to contract even further this year.

According to Bloomberg statistics, the Nifty Smallcap 100 index's one-year forward price-to-earnings (PE) ratio has decreased by more than 51% from its peak of 28.53 times in March 2021 to just around 14 times right now. Comparatively, the one-year forward PE for the Nifty 50 has decreased by over 37% from its top of 27.8 times in December 2021 to its present level of 17.4 times.

More significantly, small-cap stocks are currently at their lowest relative value level to their Nifty 50 peers since July 2020—the height of the COVID-19 pandemic in the nation. In terms of one-year forward PE ratio, the Nifty Smallcap 100 index is now trading more than 20% below the Nifty.

A positive turnaround for small-caps has historically occurred when there is a discount of more than 20% between the values of the two indices, which causes the discount to reduce.

When companies are offered at such fair prices, it is a good moment for long-term investors to buy. We may argue that the risk-reward ratio has improved for long-term investors in India, according to Arvind Kothari, founder of the fintech business Niveshaay and portfolio manager for Smallcase.

However, Kothari cautioned that discount in values should not be regarded in isolation and advised investors to consider businesses that generate cash flows, have a sound balance sheet, and are accessible at fair valuations.

In the hopes that things would improve in a year or two, investment decisions shouldn't be made in stocks that appear to be undervalued. Hope is never a strategy, and such businesses are typically devalued in marketplaces as competitive as the current ones, Kothari continued.

Concerns that domestic economic growth may slow down significantly in 2022 as a result of higher global commodity prices and higher interest rates are likely contributing factors to the de-rating or decline in valuations of small-cap companies. Higher interest rates make it difficult for investors to price profits far into the future into the current stock price.

Interestingly, seasoned investors like Shankar Sharma have recently advocated for small-cap stocks as well. Sharma tweeted, "This is the best opportunity to acquire excellent Indian small caps in the next ten years."

Analysts predict that the small-cap area may take some time to recover, even though valuations have become more reasonable, as investors' willingness to take on risk has decreased as a result of the prolonged bear market that has occurred over the previous four months.

"Since the small-cap index has experienced several breakdowns, I won't be taking a position in this market because overall sentiment isn't favourable." According to InCred Equities vice president Gaurav Bissa, any near-term gains should be used to reduce holdings in the small-cap sector.

Small-cap stocks, according to Bissa, are unlikely to take the lead in the Indian stock market's recovery. The Nifty would rise alongside the resurgence, not the other way around, according to Bissa.

Nevertheless, as evidenced by the increase in inflows to small-cap mutual fund schemes, retail investors have been buying the downturn. According to data from the Association of Mutual Funds in India, the average monthly inflow into small-cap equities funds in the first five months of 2022 increased 364 percent to Rs 1,621 crore from the last five months of 2021.