Smallcap shares take big hit; should you buy, hold or sell stocks?

Monday's 2 per cent sharp fall in the BSE Smallcap index on Monday did not surprise many. There has been prevailing concerns over valuations of midcap and smallcap stocks, with the recent February data suggesting a moderation in mutual fund flows to smallcap schemes.

Sebi also recently directed mutual fund (MF) players to put in place an investor protection framework in the wake of build up of froth in the space. The market regulator's move came following the initial round of stress tests to see if smallcaps can manage huge redemptions in the event of a market downturn.

By the end of last week, about 428 or 45 per cent of BSE Smallcap index constituents were down over 20 per cent from their 52-week high levels. A total of 169 of these smallcap stocks had hit their 52-week highs in 2024 itself.

Should you press panic button?

Smallcaps are all about bottom-up investing and analysts said while the rich valuations may cap upside in the short run, the long-term prospects for many smallcap companies are strong.  

"Fundamentally, the smallcap250 index has seen drastic improvement in earnings growth (26 per cent CAGR over FY22-24) supported by overall good economic recovery post COVID; market share gain led by formalisation of economy; and strong balance sheet improvement across sectors. In addition, policy initiatives around Make in India and PLI incentives should drive positive delta change in earnings across different sub-segments particularly in the smallcap space," said Ankit Jain, Senior Fund Manager at Mirae Asset Investment Managers (India).

The BSE Smallcap index is up 60 per cent in the last one year. The NSE Smallcap250 index has delivered similar returns. Jain said Nifty Smallcap250 is trading at around 22 times EPS on 1-year forward basis, which is at 21 per cent premium to historical average and almost 50 per cent premium to valuations around March 2018 levels.

"The market breadth is declining, which is a sign of mean reversion in mid/small cap stocks from over bought trajectory. Mid and small cap indices have rallied 35 per cent since October 2023. Intermediate corrections to the tune of average 12 per cent in mid and small caps have been a bull market norm. At present 8 per cent correction is behind us," ICICI Securities said in a note.

Jain of Mirae Asset Investment Managers sees good earnings momentum in smallcap space and maintain positive long-term stance, even as he believes expensive valuations may cap near-term performance.

"While we believe some amount of valuation premium against past is justified given overall improvement in earnings growth visibility and return ratios, though find certain pockets of the segment expensive. We do find sectors like financials, consumer discretionary and pharmaceuticals offering reasonable risk reward in the near to medium term," he said.

For the day, the Nifty Smallcap 250 was down 2 per cent at 14,494.15. The index has fallen a total 4.4 per cent in four of last five sessions.