Is Extraordinary Spike In Midcap, Smallcap A Bubble Ready To Burst? Tips On Investment Strategy!

Lately, the midcap and smallcap performance has been inspirational in Indian markets as they continued to hit back-to-back new highs. The trading week that ended on September 15 was no different as the Nifty Midcap 100 and Nifty Smallcap 100 indexes registered a new 52-week high of 41,686.75 and 13,079.20 respectively. Also, about 33% of net inflows in the equity mutual funds are from midcaps and small-caps. Since the onset of FY24, investors have enjoyed the extraordinary run of these stocks, however, this has also fueled cautionary critics over the sky-high valuations as many experts believe this meteoric rise is a result of irrational exuberance. Some even believe this over jauntiness in midcaps and small-caps is like a bubble which in every other case tends to burst.

Although, in a short-term case, it looks like investors are chasing momentum and infusing more capital into mid and small-cap stocks, as Gopal Kavalireddi, Vice President - Research at FYERS, the larger time frame reveals a different perspective.

How have midcaps and small caps performed against Nifty:

Inflows in equity mutual funds jumped for the fifth consecutive month in August to Rs 20,245 crore, registering a 165% rise. Kavalireddi pointed out that of the total inflows in equity MFs, Rs 6777 crore (33 per cent) net inflow was into mid and small caps.

Also, since the start of FY24, the 50-scrip benchmark Nifty has given 14.2% returns, alongside the 36+ per cent return from the Nifty midcap indices and a 40+ per cent return from the Nifty small-cap indices, data cumulated by Kavalireddi revealed.

As per Kavalireddi, since FY22, net flows into large-cap mutual funds continued to decrease. From 8.2% of total equity net flows in FY22, the net flows dropped to 5.7% in FY23 and witnessed a de-growth of 12.1 in FY24 (April to August). In the same period, Mid-cap mutual funds inflows increased from 9.9% to 19.2%, while small-cap fund flows rose from a mere 6.2% to a remarkable 41.9 per cent in FY24.

Data gathered by FYERs research VP showed that markets were underperformance from 2017 to 2020. However, after the outbreak of the Covid-19 pandemic, there has been a significant rise in investor participation which led FY21 and FY22 to be a very rewarding period for these participants.

However, the trend reversed during FY23 owing to geopolitical tension and macroeconomic risks, which resulted in the Nifty 50 and Nifty midcap indices delivering flat returns, and the Nifty small-cap 100 falling to a negative return of 13.8%.

"Recognizing the undervaluation in mid and small caps in light of the improving economic environment, vigilant investors moved their allocation from large caps to mid & small-cap segments of the market," the FYERS expert said.

So what is motivating the excitement in midcaps and smallcaps? Here's what an FYERS expert pointed out:

Investor participation in the stock markets has increased tremendously over the last few years, especially since the Covid pandemic. Demat account openings are currently clocking around 3 million a month. As of August 2023, demat accounts opened are up by 25.8% year-on-year. The total demat account tally stands at 12.66 crore in comparison to 4 crore accounts as of March 2020.

Improving the economic environment and government reforms across sectors opened up immense opportunities for all investors - domestic and overseas to explore and invest in companies beyond the top 100 market cap firms. These tailwinds resulted in a renewed focus on mid and small-cap companies with growth potential and lower valuations.

Over the last few years, balance sheet cleanup, IBC implementation, lower interest rate cycle, divestment plans and government capex in public sector companies, PLI schemes resulted in the opening of opportunities in railways, defence, electronic manufacturing, electric vehicles, green energy and utilities. Most companies in these undervalued segments were from the mid and small-cap categories.

Between Jan 2021 and Sep 2023, most of the 129 IPOs listed on the stock exchanges were from the mid and small-cap categories. The Small and Medium Enterprise (SME) primary market has also been vibrant. The number of actively traded stocks on BSE stands at 4100, with fresh additions regularly. With only 100 companies in the large-cap category, investors realized that 97.5 per cent of the market comprises mid and small-caps. With such a broader choice available for stock selection, the fund flows from new investors and mutual funds moved into these segments.

How should investors approach this segment?

Kavalireddi explained that a few segments of the mid and small-cap category have seen a tremendous rise in stock prices, owing to the bulging order books and capex investments by the government and private sectors. Capital goods, engineering, Realty, metals, and PSUs in banking, railways, defence, and shipbuilding have seen a turnaround in their fortunes and investor interest. Across manufacturing companies, the latest metric employed is market cap to order book, a marked deviation from the price-to-earnings, price-to-book, or price-to-sales metrics used over the decades.

While it is good to invest in companies with good order books which provide revenue visibility over the longer term, he added, "execution of the order book remains a critical factor." Adding he said, with election season coming up and governments in a spending mode, many orders across segments of the economy will see a substantial build-up.

To long-term investors, Kavalireddi guided that they must track the implementation and execution of these projects to remain invested in the companies.

To short-term investors, he said, they can take their foot off the pedal from infusing fresh funds into some sectors, as the stocks are well-priced or overpriced to their FY24, FY25 and, for certain companies, FY26 earnings growth too. Sector rotation in investing is a common phenomenon and is bound to happen continuously. Investors can choose companies from financials, IT, Pharma, consumer durables, discretionary consumption, textiles, or other under-invested and reasonably valued sectors.

He added, "While large caps are well-discovered, with steady cash flow growth and business prospects, offering consistency in returns to investors, the mid and small-caps show immense potential for wealth generation in the coming years. Not all mid and small caps will stand the test of time. Hence, investors need to pick and choose the right stocks from the sectors that are the building blocks of the rising Indian economic prospects."

India's vision of a $5 trillion economy backed by manufacturing and service exports needs many such mid and small-cap companies to rise and contribute with newer products and applications, well supported by visionary management, he said.

Lastly, Kavalireddi said, "Staying invested in high-risk- high-reward mid and small firms is a journey. Many companies will undergo a rerating based on their growth potential and financials, resulting in fast-paced stock price movements. Investors should adopt a strategic allocation policy to a few core sectors and use the tactical allocation policy to take advantage of timely corrections."

Disclaimer

The recommendations made above are by market analysts and are not advised by either the author nor Greynium Information Technologies. The author, nor the brokerage firm nor Greynium would be liable for any losses caused as a result of decisions based on this write-up. Goodreturns.in advises users to consult with certified experts before making any investment decision.