Small-cap surge leaves Street divided

Interestingly, buyers, too, are neatly arrayed on opposite sides of the aisle, with retail investors shovelling money into small-cap counters with an almost religious fervour while institutions are taking a more guarded approach.

The recent spell of profit-booking notwithstanding, mid- and small-cap stocks are the undisputed winners of the current rally. Against the benchmark Nifty’s 30% jump over the past 12 months, the Nifty Midcap 100 index has climbed 57% and the Nifty Smallcap 100 a cool 65%.

 

Some constituents seem to have escaped the Earth’s gravitational pull altogether, including names like Indian Railway Finance Corp. Ltd (up 430%), BSE Ltd (416%), Suzlon Energy Ltd (397%) and Housing & Urban Development Corp. Ltd (328%).

What explains this ballistic run?

“When we look at the mid- and small-caps, we must understand two factors," Kranthi Bathini, director- Equity Strategy of WealthMills Securities, said. First, the increased liquidity, with retail investors pouring money into MF schemes at an accelerated pace, which in turn is driving stock prices higher. “The second aspect is most of these stocks have a low float, where even small inflows can cause exaggerated price movements," Bathini told Mint.

Not unsurprisingly, this dizzying rise has left many market watchers disoriented.

“We find the valuations of the majority of the mid-cap and small-cap stocks to be quite expensive, especially in the context of their business models as well as their own history," analysts at Kotak Institutional Equities said in a recent note.

Kotak also highlighted a peculiar nature of the current rally—price and time correction in better-quality stocks but a strong upmove in “low-quality and narrative stocks" over the past six months.

The debate around “low" and “high" quality stocks notwithstanding, this segment of the market has come under heavy regulatory scrutiny in recent weeks.

In an unusual move, the Securities and Exchange Board of India (Sebi) last month directed mutual funds to undertake a stress test of their small-cap and midcap funds.

Sebi chairperson Madhabi Puri Buch, too, observed that there are “pockets of froth" in the market, adding that it is the nature of bubbles to burst.

Not just that, even the law enforcement agencies entered the fray, with the Enforcement Directorate (ED) freezing assets of a Dubai-based “hawala operator" who allegedly channeled illicit funds into mid, small and microcap stocks.

While letters like PE, PB and RoA are par for the course, even the staunchest of investors can get cold feet when the letters ED pop up on screen.

This drumbeat of alarming headlines triggered a sell-off in these counters, prompting some participants to fret over a repeat of 2018, when the small-cap index had crashed around 45%.

But not everyone is so pessimistic.

For one, domestic macro is much stronger now, with the GDP growth soaring to 8.4% in Q3FY24 and all engines of growth firing in unison.

The 2018 fall was also driven by broader market sell off (Nifty dropped 7% during Jan-Oct 2018) on peak valuations (23% premium to previous 5-year mean) while the broader market valuation is still palatable currently at around 8% premium to 5-year mean.

"2018 was a period of several other adverse events—Infrastructure Leasing & Financial Services Ltd (IL&FS) led crisis to LTCG tax to the global tightening cycle while in the current context there is hope of rate cuts in the second half of the year," HSBC Global Research said in a report on 21 March.

HSBC added that it remains constructive on the broader market and any deep sell-off in midcaps from current levels seems unlikely.

Investors can also take heart from the fact that the smallcap show has not been ‘all talk and no show’.

During FY21-23, large-caps have delivered earnings growth of around 21% compared to 31% for mid-caps and 48% for small-caps.

Even in Q3FY24, profit after tax growth of BSE500 at 25.5% year-on-year outpaced that of Nifty 50 at 16.30%.

Fundamentals may just be in place, but does that justify the flights of fancy?

Adherents of the ‘high risk high reward’ style of investing point out that volatility is a feature, not a bug, when it comes to midcaps. Knee-jerk reactions to headlines will only harm investors.

“I think serious money can only be made in mid- and small-caps. But investors need to be highly stock-specific in this segment. They should prioritize companies with good earnings visibility, strong fundamentals and competent managements. If they follow these basics, the market will reward them generously," WealthMills’ Bathini added.