Contrarian view: 4 reasons why Anand Rathi expects midcaps and smallcaps to outperform in the upcoming year

While investors in midcap and smallcap stocks have faced disappointing returns in recent times due to regulatory crackdowns, a broader perspective reveals their resilience and potential for substantial gains. Despite short-term setbacks, these stocks have maintained their status as outperformers compared to largecaps, particularly evident when analyzing their one-year returns.

Over the past 12 months, small and midcap stocks have delivered impressive returns, around 50 percent, demonstrating their capacity to create substantial value for investors. This trend underscores the attractiveness of these stocks for those willing to embrace volatility and seek opportunities for substantial growth in their investment portfolios.

However, just in March, the Nifty Midcap index has lost 3 percent so far while the smallcap index has crashed over 6 percent. In comparison, the benchmark Nifty is up 0.17 percent.

Read here: Bull run ends here! Phillip Capital sees Nifty 50 falling 15% to 18,550

Amid widespread concerns over froth formation in the Indian equity market, the brokerage stands out with a contrarian perspective. While many voices express apprehension, the brokerage contends that the Nifty 50 and Nifty Largecap 100 are presently fairly valued. In contrast, it sees substantial upside potential in the Nifty Smallcap 250 index.

“Even if we tone down consensus earnings expectations and take valuation multiples lower than ‘normal’ in this phase of the business cycle, we observe no valuation froth,” it said in a recent note.

Read here: Smallcap, Midcap index: 4 reasons why J.P. Morgan sees 5-10% more downside risk

Despite a recent short-term correction, domestic brokerage house Anand Rathi expects small and midcap stocks to outperform largecaps over the upcoming year. It has cited four compelling reasons for the same:

Historical precedence: The historical trend of mid and smallcaps outperforming largecaps, notably observed from 2014 to 2017, provides a strong foundation for this expectation. This historical pattern suggests a propensity for smaller companies to exhibit greater growth potential compared to their larger counterparts.

Rebounding from lows: The significant gains witnessed in the past 12 months can be attributed to a rebound from substantial underperformance endured in 2018-19, and again in 2022. This recent surge is perceived as a necessary catch-up phase rather than an anomaly, indicating a potential for sustained growth momentum.

Read here: History repeats? Is the surge in mid and small-cap stocks similar to that of 2018?

Fundamental strength: The upswing in mid and smallcaps is underpinned by robust earnings growth, with a compounded annual growth rate (CAGR) of 30 percent and 37 percent, respectively, since 2018. In contrast, largecaps have exhibited a comparatively modest CAGR of 16 percent. This fundamental strength suggests that smaller companies are poised for continued growth and profitability.

Valuation Justification: Despite a noticeable decline in risk-free interest rates, typically associated with higher equity multiples, the valuation metrics for mid and smallcaps do not appear excessively inflated. This suggests that the current valuations are justified by underlying fundamentals rather than speculative froth.

In light of these factors, Anand Rathi advocates a favorable stance towards mid and smallcaps for investors with a horizon extending over the next 12 months. These insights underscore the potential for superior returns and growth opportunities within the mid and smallcap segments of the market.

Read here: Midcap, smallcap could continue to underperform in short term; here's why

Outlook

Anand Rathi expects the one-year return would be near the long-term average for Nifty 50 and Largecap 100, below the long-term average for Midcap 150, and significantly above the long-term average for Nifty Smallcap 250.

It also sees earnings growth of Nifty 50, Nifty Largecap 100, Nifty Midcap 150, and Nifty Smallcap 250 in FY25 and FY26 to be robust at over 11 percent. In fact, it sees small-cap companies recording strong earnings growth.

Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of Mint. We advise investors to check with certified experts before taking any investment decisions.