Mid and small cap stocks have outperformed large caps by far since July this year. The Nifty Midcap Index has returned 17.1%, while the Nifty Smallcap Index is up 14.8% over this period, compared to a return of 11.9% for the Nifty 50.
Following the recent run up, the Nifty is now trading at 19.5x the one-year forward against earnings multiples, above the 10-year average of 16.9. Mid-caps are trading at a 10-15% premium to the Nifty, while small-cap indices are trading at 15-16 P/E, slightly above the long-term average of 14.4x, experts say.
“Mid and small caps have started to outperform Nifty since July on attractive valuations, FPI cash inflows and better-than-expected earnings growth,” said Ajay Menon, MD & CEO, brokerage and distribution, Motilal Oswal Financial Services.
The decline in the broader market was much stronger than the Nifty’s in the first half of the year, making valuations in many of the counters really attractive and attracting investors, Menon said.
“Despite the impact of inflation, these companies managed to manage their operating margins quite well, giving investors confidence. The festive season also started with a bang and led to a spurt in consumer demand, especially in the discretionary space. Niche sectors and themes such as travel and tourism, QSR, retail, construction materials and defense have received a lot of interest in acquisitions and are likely to remain in focus in the coming months,” Menon said.
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What has also helped is the orientation of mid- and small-cap segments towards sectors such as capital goods, chemicals, construction materials and consumer durables, which tend to focus on the domestic market, which is relatively more isolated than outward-looking sectors such as IT and pharmaceuticals. .
FPIs sold shares worth $28 billion in the six months to June, but became net buyers in July and August. Since September, they have sold shares worth $1.5 billion. FPIs typically prefer to trade in large-cap companies rather than mid- or small-cap companies. In contrast, domestic institutional investors such as mutual funds have been net buyers for most of this year thanks to continued influx of retail investors including systematic investment plans of Rs 12,000 crore per month.
Mid and small cap segments typically take a bigger hit than large cap stocks when market conditions turn unfavorable. In 2018, mid- and small-cap stocks fell between 12% and 20% on average, sparking investor panic.
“The strong outperformance of the small cap index versus Nifty after April 2020 has brought attention back to this segment. Fortunately, as this segment outperformed Nifty and praised large-cap premium valuations, CY17’s excesses were not repeated in this cycle. So while valuations are high and buoyant bubbles are visible, the segment as a whole has not reached December 2017 levels,” said Anoop Bhaskar, head of equities at IDFC MF.
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That said, with markets likely to experience several headwinds in the form of rate hikes by global central banks, geopolitical tensions and economic slowdown, experts advise investors to limit their exposure to such stocks to 30-35% of their equity portfolio.
“We believe the global slowdown and India-specific risks could act as a catalyst for earnings cuts. Given current valuations and the potential risk of global events turning out unfavorable, we would seek solace in large caps for now,” said Amish Shah, head of India Research, BofA Securities.