Smallcap segment can suffer more; time to avoid the sector? Experts weigh in

The relentless rise of the smallcap segment seems to have halted as the segment has been witnessing remarkable profit booking in the recent past following an eye-popping rally in the last one year. The Nifty Smallcap 100 index is down nearly 6 per cent since February this year while the benchmark Nifty 50 is up nearly 3 per cent. Nifty Midcap 100 index is down about a per cent for this period.

However, despite this decline in the last one and a half months, the Nifty Smallcap 100 index is up about 68 per cent for the financial year 2023-2024.

The steep rise in the index shot up its valuation, fanning fears among investors that the smallcap space was too hot to sustain its gains. A deep correction was expected which the segment is witnessing now. The Nifty Smallcap 100 index is now 10 per cent down from its all-time high of 16,691.60 which it hit on February 8, 2024.

Also Read: Nifty Smallcap 100 index tumbles another 2.5%, down over 6% in March so far; here's why

More pain in the offing?

Experts see more pain for the smallcap space as its valuation is still very high.

"Though it is difficult to guess the quantum, but 10 per cent correction cannot be ruled out. If it happens it would be healthy and bring some sanctity to the exorbitant valuations," said Sneha Poddar, AVP – Retail Research, Broking and Distribution, Motilal Oswal Financial Services.

"The sector is undergoing a healthy correction, especially after the rally of 60-70 per cent over the last one year. Post such a sharp rally, the valuations have got stretched in many pockets with Nifty Smallcap100 trading at over 21 times one-year forward PE (price-to-earnings ratio) which is a 35 per cent premium to its 10-year average," said Poddar.

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Arpit Jain, Joint MD at Arihant Capital also expects at least 10 per cent correction in this space.

"We acknowledge a modest correction within the sector, with the possibility of a 10 per cent adjustment. Additionally, considering it's year-end, profit booking is prevalent among investors, contributing to this correction alongside valuation considerations," said Jain.

Trivesh D, COO at Tradejini sees several factors at play behind the correction in the smallcap segment.

"This correction could be driven by a few factors. Firstly, regulatory concerns regarding excessive inflows into small-cap funds raise questions about the ability to maintain portfolio quality due to the limited pool of investible small companies. Secondly, potential regulatory actions to address frothy valuations and the ongoing correction in the broader market are likely to exacerbate the downward pressure on small caps," said Trivesh, adding that given the current, still-elevated valuations in small caps, a further correction reaching 10 per cent isn't out of the question.

Also Read: Euphoria of mid and small caps will consolidate going ahead, says market expert

Ajit Mishra, SVP of Technical Research at Religare Broking pointed out that the smallcap index has reached closer to its critical trendline support around 15,000, which also coincides with the short-term moving average i.e. 20 WEMA (weekly exponential moving average). Mishra believes a decisive break below that mark could further dent the sentiment and may result decline towards the 13,900 zone.

Time to avoid the sector?

A complete avoidance of the sector may not be a prudent move as there are still some quality stocks in the sector that have the potential to move higher in the medium to long term.

As Trivesh observed, while a correction extending to 10 per cent cannot be ruled out, it's crucial to acknowledge the inherent resilience of the Indian small-cap sector. Historically, small caps have demonstrated the potential for significant long-term compounding, driven by the dynamic nature of the companies and their ability to adapt to evolving market conditions.

"Small caps, while offering the potential for significant gains, also carry inherently higher risks compared to their larger counterparts, tempting retail participants seeking high returns. Therefore, for retail investors, selective investment becomes critical. The focus should be placed on identifying high-quality businesses with a strong track record of financial health and long-term growth potential. These companies often exhibit resilience in the face of market fluctuations," said Trivesh.

Prioritizing risk management is essential which involves conducting thorough research before investing in any small-cap stock, maintaining a well-diversified portfolio across various asset classes, and ensuring your investments are aligned with risk tolerance.

It's crucial to understand that corrective phases are natural occurrences within the market cycle and often lead the way for long-term value creation, said Trivesh.

Poddar said in the near term, investors should switch to large caps where the risk-reward is favourable. In the meantime, the investors should also take this correction as an opportunity to accumulate quality names for the long term.

Poddar added that the overall long-term trend remains intact as India is currently enjoying the best of both macro and micro tailwinds with nearly 7 per cent+ GDP growth, moderating inflation numbers, rangebound crude prices, easing 10-year G-sec yield, stable currency, and resilient corporate earnings.

Jain of Arihant Capital recommends retail investors focus on accumulating larger mid-cap stocks that have experienced corrections, rather than solely targeting small-cap stocks at current levels. Moreover, considering adjustments in the portfolio, a strategic increase in the share of large-cap stocks is advisable for a balanced approach, he said.

Ajit Mishra advises avoiding longs in broader indices and suggests preferring index majors until we see some sign of reversal. He said traders should utilise recovery to reduce their existing longs, if any.

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