A tale of the two caps

The stock market’s meltdown since the beginning of the year has taken a huge toll on small- and mid-cap stocks. This time last year, small- and midcap stocks were market favourites as foreign investors were investing huge sums of money in them.

Such investors are normally reluctant to buy in small- and midsized counters because of the lack of liquidity and their smaller ticket size. Their fast-paced growth rates, however, attracted the big-league investors to these stocks. But the last four months have changed all that.

Foreign investors have been dumping small- and mid-sized companies in favour of the sturdier large-cap companies. One reason is that the large-caps valuations have shrunk to reasonable levels, attracting the attention of foreign investors. Another reason is the vanishing liquidity in small- and mid-cap counters. Since the beginning of this year, small- and mid-cap stocks have underperformed the Sensex. While the Sensex has corrected 17.7 per cent since January 1, 2008, the smalland mid-cap indices have lost 35.8 and 28.9 per cent, respectively.

But the one-year performance is still heartening—the small- and mid-cap indices gained 25.6 and 22.9 per cent, respectively, against the Sensex’s 18.11 per cent.

Small- and mid-cap stocks have an inherent disadvantage: they are not liquid. Many stocks see trades of about 500-1,000 shares a day, making them prone to high volatility if there are bulk orders. As there’s not much trading, a small buy-side order sometimes can push these stocks to hit upper circuit filters.

But Rajen Shah, Head of Research, Angel Broking, feels that investors need not worry much about liquidity, as over time these companies will grow in size and liquidity will increase in these counters. Shah reasons that five years ago, companies like ONGC had trading volumes of about 1,000 shares a day, but now the volumes have increased manifold. Says Shah: “Volumes are not a concern if the fundamentals are in place.”

The small- and mid-cap show, however, is not over yet. Recently, these stocks have been getting favourable analyst ratings and retail interest in them is crawling back. As smalland mid-cap stocks have corrected significantly, many fundamentally sound companies are now available at valuations that are much lower than the broader market. Says Shah: “There’s a lot of value in small- and mid-cap stocks. With the economy doing well, all companies are getting an opportunity to expand their business. Ultimately, their stock prices will benefit. Many excellent midcap stocks are available at single digit P-E multiples.”

But, it may be a while before the small- and mid-cap stocks replicate last year’s momentum, as big investors are focussing on the larger companies. Of course, a lot depends on how long it takes for the markets to recover. And a lot also depends on how the small- and mid-caps companies perform in a slowing economy. Then again, they may still be able to maintain their above-average momentum.

— Clifford Alvares