When markets rise in euphoria, they lift stocks across categories. It is often seen that during bull runs, many small-cap stocks become multi-baggers followed by midcaps who handily beat their larger peers. This pattern is visible even in the current market rally.
There is however, one leveller - the return on equity (RoE). All stocks eventually gravitate to their long term RoE. If a stock gives a return greater than its RoE, there is a high probability that its share price will revert back to its sustainable RoE. There is a caveat though: this phenomenon holds true only when the duration is of three years or more.
We dug in and looked for the number of companies that have gained (annually) more than their three-year average RoE across indices. The results show small-cap index is the most overvalued with 61 per cent of the total companies overvalued. Midcaps are not far away with nearly one out of two midcap stocks overvalued. Large-cap stocks are the least overvalued with only one out of three stocks overvalued. Time to go large-cap fishing.
3 year stock return vs 3 year average RoE
| Total No. of companies | Cos with return below RoE | Cos. with return above RoE | Per cent of over return | |
| Sensex | 30 | 22 | 8 | 26.67 |
| BSE-100 | 100 | 64 | 36 | 36 |
| BSE Midcap | 251 | 115 | 136 | 54.18 |
| BSE Smallcap | 415 | 161 | 254 | 61.2 |
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