“The concept of mean reversion is the most powerful tool in the investor’s toolkit.” – Jeremy Grantham
Jeremy Grantham is a well-known investor and co-founder of GMO LLC, a global investment management firm. This quote underscores the importance of mean reversion as a guiding principle in finance, suggesting that over time, asset prices and financial indicators tend to revert to their historical averages.
What this essentially means is that the returns from financial assets normally hover around an average. However, at times they diverge significantly from the historical average. What we can be sure is that periods when returns are too high are followed with periods when returns fall below average and vice versa.
Let us look at the past performance of various NIFTY indices to understand how high or low current performances are compared with historical averages.
NIFTY small and mid-cap trailing performance has rarely been this high
Few broad points that we can make from latest performance statistics are:
- The latest 5Y and 10Y trailing return for NIFTY 50 index is broadly in line with long-term average performance.
- However, this is not the case for NIFTY small cap and NIFTY mid cap index. NIFTY mid-cap and small cap trailing %Y and 10Y return is significantly above average (more than 1 standard deviation above historical average). In fact, NIFTY mid-cap 5Y CAGR of 19.9% is in 85th percentile. This means that only 15% of the time(since 2010), the returns have been higher than this level.
- Small and mid-cap indices have not delivered significantly higher return than the NIFTY 50 index in past on a consistent basis. The average return of NIFTY 50 over 5Y and 10Y is similar to the average returns delivered by small and mid-cap indices. Hence, current period of outperformance is not very common. This means that when small and midcaps significantly outperform large cap index, they are likely to underperform in subsequent period.
NIFTY small and mid-cap valuation is expensive relative to NIFTY 50
Based on P/E and P/B, NIFTY mid and small cap indices are trading above their median valuation. While the valuation of NIFTY 50 index is not very attractive either, it does appear to be the less expensive segment of the market. Based on dividend yield, the valuation of NIFTY 50 is expensive also. So, we are in a scenario where trailing performance as well as valuations indicate a period of price correction or at best consolidation, especially for mid and small caps.
It makes sense to prune exposure to mid and small cap funds
Mid and small caps had a great run. Investors who had exposure to these segments of the market have made good money over the last couple of years. However, there comes a time when one needs to make a decision about how much further upside he or she is willing to sacrifice to protect the gains already made thus far. While there is lot of confidence in the market, it does not taken lots of time to change things. Mid cand small caps can correct pretty violently in a very short period of time.
Hence, it does make sense to book profit and let the market clear the froth in mid and small caps either through a time correction (no further move up in these stocks for some time) or price correction.
Disclaimer: The above content is just for information and should not be construed as an offer to buy or sell or recommendation. Contact your financial advisor for guidance on any investment related query.
If you liked the above article and would prefer to be notified when we write next, please leave your contact details below: