Small-Cap Indices Recover To Previous Levels Despite Sebi’s Caution: What Do Experts Feel About Its Future?

Small and mid-cap stocks did not succumb to Sebi’s caution and recovered to the same levels as before. Here’s what experts have predicted on the small and mid-cap space and the potential outperformers
Small-Cap Indices Recover To Previous Levels Despite Sebi’s Caution
Small-Cap Indices Recover To Previous Levels Despite Sebi’s Caution

Small-cap indices have almost erased recent losses triggered by warnings from the Securities and Exchange Board of India (Sebi) regarding froth in the small- and mid-cap space. Despite Sebi’s caution, investor sentiment continues to remain bullish in this segment especially, as small- and mid-cap stocks have seen huge inflows in April, historically.

A remarkable nine-day rally in the BSE Small-Cap index has reclaimed the same levels just 300 points short of levels last observed on February 27, 2024, when Sebi’s cautionary advice to investors momentarily dented bullish sentiment.

As of March 4, 2024, at approximately 11:50 am, the index surged by over 2,264 points or 5.20 per cent, reaching 45,659 points, just 300 points short of 45,888 on February 27, according to Google finance data.

What Do Market Experts Say?

Chandraprakash Padiyar, senior fund manager, Tata Asset Management says that “going ahead, one should not generalise from a market capitalisation perspective since we are now likely to see variations in corporate earnings delivery relative to expectations across market caps. We think stock selection and active funds are likely to do better than passive investing over the next few years.”

On being asked about outperformance predictions for large-caps in FY25, he says that the mid-cap segment will not outperform the large-cap segment, and similarly, small-cap indices may need to consolidate in a range for some time given the global growth slowdown.

Padiyar says that capital goods, engineering, housing ancillary, banks and value-added steel products have the best earnings momentum over the foreseeable future, and stock selection in these segments can generate healthy returns.

Deepak Ramaraju, senior fund manager, Shriram Asset Management Company (AMC) says that the small-and-mid-cap (SMID) categories have stretched valuations, and off-late, investors after booking profit from the SMID category, have diverted the gains to large-caps.

“This trend will continue in the medium-term, as the valuation gaps will get narrowed between the large and SMID categories. SMID caps will outperform the large-caps when once the valuation gap narrows. However, the outperformance will be limited in comparison to FY24. For FY25, the market expects that SMID earnings growth will still be higher than large-caps, because market expects lowering inflation leading to rate cuts, as well as BJP returning to power and increasing the government spending,” Ramaraju says.

Umeshkumar Mehta, chief investment officer, SAMCO Mutual Fund says, “Currently, it is unlikely that small- and mid-cap indices will significantly outperform large-cap indices in FY25. This is primarily due to the high valuations of these indices, which suggests poor expected returns over the long term.”

Chakravarthy V., co-founder and director, Prime Wealth Finserv has a different view from mutual fund houses. “The small- and mid-cap market has already stretched a lot in FY24. We don’t see any likeliness of small- and mid-caps surging again by a significant margin. There might be a reversal in cyclical sector. We might see large-caps performing better in FY25, and it may prove to be the new winners,” Chakravarthy says.

Performance Disparity In Active And Passive Funds

Around 73 per cent of actively managed mid- and small-cap funds underperformed their benchmark in 2023, whereas in large-cap funds, around half of them outperformed their benchmarks.

Padiyar says the disparity in performance between actively-managed mid and small-cap funds vis-a-vis large-cap stocks compared to their benchmarks in 2023, is just a seasonal trend. “In 2019 to 2022, small-cap funds outperformed the benchmark index by a wide margin, and in 2023 some amount of that outperformance came down. There is generally a lead lag in terms of stock selection and market movements,”Padiyar says.

Padiyar adds that during periods of sharp broad-based market rallies, active managers tend to underperform indices like how it happened in 2023, while active managers usually fare better during normal or a weak market.

Ramaraju feels that the underperformance of SMID active funds was due to practical reasons. According to him, mid-cap and small-cap funds face challenges in maintaining adequate liquidity.

“This has forced many mid-cap and small-cap funds to hold a few large-cap stocks up to 10 per cent of their portfolio on average in 2023. Some of these large caps delivered meagre returns in comparison to mid and small cap stocks,” he adds.

In addition, most mutual funds have stringent norms of quality and a past track record resulting in limited exposure to public sector undertaking (PSU) stocks in the SMID category. But PSU stocks outperformed expectations. On the other hand, due to same reasons of maintaining quality filters and past track record criteria large cap funds outperformed the benchmarks in 2023, he clarified.

According to Chakravarthy, the underperformance of small and mid-cap active funds with large-cap funds is due to inherent volatility and liquidity challenges in the mid- and small-cap sectors.

“These challenges complicate stock selection and timing. Conversely, large-cap funds benefited from a more stable macroeconomic environment and the resilience of large-cap companies to market fluctuations,” Chakravarthy says.

Sebi’s Froth Warning: Impact on Small and Midcaps

Regarding Sebi’s concerns about frothy valuations in the small and mid-cap space along with mutual fund stress tests, Padiyar acknowledged overvaluation concerns, but only minimally. He remained optimistic about the performance of small and mid-cap businesses, but noted that return expectations need to be adjusted, as the base valuations have returned to normal levels, compared to the attractive levels seen earlier.

“India earnings outlook is probably still at an early stage of the cycle and there is room for earnings to move higher over the mid- to long-term period. We have a positive outlook on the performance of small cap and mid cap businesses in the market,” Padiyar says.

According to Mehta, small-cap and mid-cap valuations currently command a considerable premium over large-cap counterparts.

“Lump sum investments during such periods may not yield returns commensurate with the associated risks. A case in point is the Nifty Mid-cap 100 index to Nifty 50 index ratio. It currently stands at approximately 2.20, compared to just 2.05 at the peak of 2017. It took nearly three years for the Mid-cap 100 index to reach similar levels again,” Mehta further says.

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