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

Mid and small-cap stocks have witnessed exorbitant returns in the last 1 year with both the Nifty Midcap as well as the Nifty Smallcap indices surging around 50 percent. In comparison, the benchmark Nifty was up over 29 percent in this period.

However, both the broader market indices have been correcting since February this year.

"From a premium of 24 percent and 29 percent for Mid and Small Caps over Nifty in early February 2024, which sharply corrected to 14 percent for both. Partly on account of relative strength in Large Caps and sharp correction in Small Cap Index of 12 percent from February 2024 peak," said Motilal Oswal AMC in a recent note.

The AMC further pointed out that smallcaps are also in the process of settling in a premium band just like midaps already have settled into. Largecaps in any case are available at reasonable valuations of 22.70 on TTM PE and have only recently begun to strengthen

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

But does the high valuation of SMID stocks remind you of 2018? First, let's understand what happened in 2018.

In early January 2018, the Indian equity markets were characterised by exceptionally high valuations across all segments, with the Nifty 50 trailing twelve months price-to-earnings (TTMPE) ratio standing at approximately 28. This trend was indicative of a market that had reached peak levels, exacerbated by Small and Medium Enterprises (SMID) trading at unsustainable premiums exceeding 100 percent over Nifty valuations. Typically, markets operating at such unsustainable levels are poised for rationalisation, awaiting a triggering event, noted report.

It further stated that this trigger materialised when the entire Mutual Fund (MF) industry found itself compelled to rebalance its portfolios out of mid and smallcaps. This shift was necessitated by regulatory mandates defining standard market cap definitions and prescribing new scheme characteristics. Consequently, the vast majority of the MF industry was engaged in rebalancing activities, effectively withdrawing support from the SMID segment of the market. With limited counterbalancing flows available, the SMID segment experienced a sustained period of weakness, said the AMC.

Additional factors further contributed to the subdued sentiment surrounding SMID stocks. The crisis within the Non-Banking Financial Companies (NBFC) sector, coupled with the anticipation of the impending 2019 elections and the subsequent introduction of capital gains tax on equity, compounded market anxieties, exacerbating the prevailing weak sentiment towards SMID stocks, it explained.

Read here: Edelweiss Small Cap Fund to take 3 days for 50% portfolio liquidation

Collectively, these factors created a challenging environment for SMID stocks, characterised by elevated valuations, regulatory pressures, and adverse market conditions, ultimately leading to a sustained period of weakness in this segment of the market.

Why is 2024 not 2018?

As per MOSL AMC, from April 2023 onwards, the SMID (Small and Medium Enterprises) segment experienced a notable surge in the market momentum, driven by several factors including discounted valuations for smallcaps and increased participation from domestic investors in mid- and small-cap stocks. This resurgence led to a significant uptick in premium valuations over Nifty, raising concerns by early 2024 about the potential for overvaluation, it said.

Moreover, recognising the risk of excessive market exuberance, regulatory intervention came in the form of cautionary measures targeting the SMID segment. The regulator took a proactive stance by engaging asset management companies and requesting stress testing for their exposure to SMID stocks, mentioned MOSL. Additionally, some asset managers halted fresh lump sum investments, further impacting market sentiment. Concurrently, regulatory bodies overseeing banking and non-banking financial sectors intervened to address concerns in NBFCs and payments businesses, bolstering market stability, it noted.

Read here: Small cap, micro-cap stocks have more room for correction, says Dharmesh Kant

However, unlike the scenario in 2018, there was no industry-wide mandate for mandatory rebalancing out of the SMID segment. Many asset managers across Mutual Funds (MF), Portfolio Management Services (PMS), and Alternative Investment Funds (AIF) continued to actively seek opportunities within this segment, indicating sustained interest and confidence in SMID stocks. Furthermore, considerations such as advance tax payments and tax management strategies around mid-March also influenced market dynamics significantly, it explained.

In summary, while regulatory caution and market interventions helped temper excessive exuberance in the SMID segment, the absence of compulsory rebalancing measures coupled with ongoing investor interest and strategic tax planning efforts contributed to maintaining a balanced market sentiment amidst heightened volatility.

Fundamentals remain strong

The report also pointed out that domestic investors’ increased participation is not dreamy; it is backed by the strong show on fundamentals by SMID. FY2021-2023, largecaps have delivered earnings growth of 21 percent compared to 31 percent for midcaps and 48 percent for smallcaps. Even recently in Q3FY2024, PAT growth of BSE500 at 25.5 percent Y-o-Y outpaced that of Nifty 50 at 16.30 percent. Going forward, FY2023-2025E is also reflecting continued strength in earnings growth for mid & smallcaps at 31 percent & 33 percent respectively vis 16 percent for largecaps, it predicted.

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.