Value strategy: Our recommended investment strategy is based on the principle of swings in ‘risk spread’ for mid- and small-caps over large-caps. It moved from zero (peak of risk appetite in Jan’18) to the current environment where it has expanded significantly for micro-caps at 700 bps (probably the peak of risk aversion) and to some extent for small-caps at 220 bps. However, risk spread for mid-caps continue to be low at just 40 bps indicating lower ‘margin of safety’.

We have defined Micro-cap as stocks with market capitalisation rank between 500- 1000 while the rest are based on AMFI classification. Risk spread is defined as the difference in trailing earnings (TE) yield between two types of stocks (Eg. Mid-caps over large caps) Amongst small / micro-caps, we prefer non-commodity stocks within our coverage universe (Add/Buy rating) which offer TE yield >= bond yield, stable earnings outlook, RoE>13%, Low financial leverage, positive FCFO and preferably have linkage to the domestic economic recovery. Our top picks include Bajaj Consumer, J.B. Chemical, Newgen Software, Cyient, Techno electric, Parag Milk and Jubilant Life sciences.

* Risk spread has risen sharply for small- and micro-caps since Jan’18 thereby providing ‘margin of safety’: Rational behaviour should ensure that the returns (earnings yield) increase as we go up the risk curve (large caps to micro caps) thereby expanding the ‘risk spread’. At the height of the mid- and small cap euphoria during Jan’ 18 the ‘risk-reward’ line flattened indicating zero risk spreads for riskier assets which was a highly irrational behaviour. Since then, the risk spread of small and micro-caps over large caps has risen significantly. Widening of risk spreads is a result of significant underperformance of small- and micro-caps to large caps since the peak of Jan’18. Risk spreads for micro-caps (> 500 rank) over largecaps in particular have risen considerably and become very attractive at 7%, which is closer to +1 s.d. of LTA.

* Risk spreads of mid-caps continue to be low: Large caps have a TE yield of 4.3% and the mid-caps TE yield is 4.7% thereby providing very little risk spread for the mid-cap space over largecaps as compared to history.

* More than 50% of the top 1000 listed stocks have a trailing earnings (TE) yield of >5%: An astonishing 503 stocks out of the top 1000 by market cap currently have a trailing earnings yield of 5% and above. We believe that the 5% TE yield is an adequate value threshold for growth assets like equities (RBI repo rate of 5.15% and we expect it to dip below 5% by Dec’19). However, the representation of >5% TE yield companies is low at 34% within the large and midcap space. On the flip side, Small- and Micro-caps (have a disproportionate share, with 64% of their universe population yielding > 5%.

* Have mid-caps really underperformed during the current cycle? Since 2004, we have observed three full cycles (2004-2009), (2009-2013) and (2013- till now) for mid and small-caps. Current cycle started in late 2013 as optimism of the first NDA win gained momentum thereby propelling the mid- and small-caps to extreme outperformance over the large caps. Sell-off since Jan’18 has ensured that the significant relative outperformance of small-caps has disappeared completely while mid-caps have held on to some of the outperformance (18% during the current cycle since 2014).

* Rational behaviour should ensure adequate risk spread applied to mid-, small- and micro-caps over largecaps: Size as a proxy for risk is validated with deteriorating ROE as we move from Large caps to Micro caps (Avg. RoE; LC: 19.4%, MC: 17.1%, SC: 15.6% and MicroC: 13.8%) and relatively weaker business models with higher mortality rate. However, exceptions to this general rule do exist where relatively small companies enjoy a dominant position in small but rapidly rising sectors.