Indian benchmark indices Nifty50, Sensex have jumped nearly 10% so far this year. While the rally is decent, midcap and small indices have outperformed the benchmark by some margin. Nifty midcap index has zoomed around 32% so far this year, and Nifty Smallcap index has rallied around 33%, delivering multibagger returns to investors
Brokerages such as Kotak Institutional Equities said the primary driver of the rally in midcap, smallcap indices appears to be irrational exuberance among investors, with high return expectations being driven by the high returns of the past few months. Analysts are a bit cautious on the midcap and smallcap space amid low margin of safety
"We do not see many fundamental reasons for the meteoric rise in the stock prices of many midcap and smallcap stocks in the past few months. The fundamentals of most sectors have not changed much," the Kotak Institutional Equities said. Meanwhile, according to Elara Capital, the recent rally in mid-/small-cap stocks may seem like overheating, but in reality is a swing-back from the extreme under-performance posted through 2018-2022
Brokerage firm Axis Securities in a note said the strong catch-up by midcaps and smallcaps in the last couple of months has lowered their margin of safety as compared to largecap stocks. "Keeping this in view, the broader market may see some time correction in the near term and flows are likely to shift to largecap stocks. However, the long-term story of the broader market continues to remain attractive," it said
Kotak Institutional Equities said in its report that the market sentiment is quite exuberant, based on steep increase in the prices, large inflows into midcap and smallcap mutual funds and huge number of new retail participants in the midcap and smallcap funds. The strong performance of the midcap and smallcap indices has possibly pushed up return expectations among retail investors, it said
According to analysts at Kotak Institutional Equirites, the last lot of the new favourite mid and smallcap stocks fall in the dubious category of ‘turnaround’ stories. "Many of these companies have been through serious operational and financial challenges (including bankruptcy) in the recent past, but the market has high hopes of these companies doing well in the future. We are not sure of the basis of the market’s confidence," it said
Kotak has dropped its recommended midcap portfolio since it could not find too many stocks beyond the BFSI space that offer decent potential upside. It said most of non-BFSI stocks are trading above at around its 12-month fair values and that valuations of stocks in its favourite capital goods, healthcare, QSR and real estate sectors discount growth for the next few years and leave absolutely no room for any disappointment
Elara Capital noted that while domestic flows into midcap and small-cap mutual funds are at all-time high, flows into India-dedicated FII midcap funds are on an upswing and have not yet reached the previous peak of 2018. History shows that the flows do not fall off the cliff. Even if the peak is passed, strong flows may continue for several months, it said
According to analysts at Elara Capital, Mid-cap/small-cap valuations are one SD above long-term average and close to previous highs (except the Covid lockdown phase). But mid-cap/small-cap valuation, relative to the Nifty, is still well below the previous highs. "We are in the early part of an earnings upgrade cycle that kicked off in early CY2023. This can support the rally despite high valuations," it said
Elara Capital said incremental index-level upside may come from cheaper (earnings growth adjusted) midcap and smallcap stocks, in which the incremental capital will flow into. "The earnings upgrade may support the continued rally in mid/small-cap stocks though these look fully valued on current basis," it said. According to the brokerage, in the past five years, Nifty Smallcap Index has underperformed Nifty. "Thus, there is still room to catch up to the long-term outperformance rate, especially for small-cap stocks," it said
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