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Decoding the Recovery

Decoding the Recovery

Large, mid and small-cap stocks have all taken part in the recent rally. Is this sustainable?

Illustration by Raj Verma Illustration by Raj Verma

The Sensex posted its best quarterly return of 19 per cent in the first three months of the current fiscal. Keeping in step, other broader indices, such as large-cap, mid-cap and small-cap, posted similar returns. But are all constituents of these indices delivering identical returns or are some of them bucking the trend?

The trigger for the rally came from retail investors and domestic institutional investors (DIIs) even as foreign portfolio investors (FPIs) pressed the panic button. DIIs pumped in Rs 88,132 crore in Indian stock markets in the first half of 2020, almost double of what they had invested in the entire 2019. Mutual funds invested Rs 39,359 crore. On the contrary, FPIs turned net sellers, pulling out over Rs 18,000 crore during the period. They had pumped in a little over Rs 1 lakh crore last year. Net DII inflows have been positive for the past five years. Rajat Jain, CIO, Principal Asset Management Private Ltd, says this long-term trend indicates the growing importance of DIIs. "We believe flows into mutual funds and insurance companies may continue to grow gradually over the medium term."

Large-caps: Repeat Performers

Large-caps, mid-caps and small-caps have all taken part in the recent rally. But they followed different paths to reach here. In 2019 calendar year, the large-cap index had risen around 11 per cent, while mid-cap and small-cap indices were in the red, falling 3 per cent and 7.2 per cent, respectively. "This was due to polarisation in favour of large-caps," says Deepak Jasani, Head, Retail Research, HDFC Securities.

The large-cap index, which covers 34 per cent of Sensex stocks and top 70 per cent of the market, is still down 10.5 per cent since the start of the year (the big slump had come in March when the nation had gone into the lockdown mode). However, some 17 stocks, including leading pharmaceutical names such as Dr Reddy's and Cipla, and FMCG majors HUL and Nestle, bucked the trend due to high demand for their products. Aurobindo Pharma led the pack here with almost 83 per cent year-to-date rise followed by other pharma stocks such as Dr. Reddys and Cipla.

Altogether, 43 per cent stocks in this space have outperformed the index year-to-date while a little over half beat the benchmark after March (all of these have returned more than 32 per cent since March lows).

Moreover, one can buy them for a song as nearly 53 per cent scrips in the large-cap space are trading below their five-year median price-to-earnings (PE) ratio. For instance, ACC Ltd is available at a 40 per cent discount to its five-year median PE ratio. Dr. Reddy's is 39 per cent below its five-year average PE ratio.

Mid cap: Better Performer

The mid-cap index, which represents the next 15 per cent market cap after the large-caps, opened the year on a positive note after last year's 3 per cent decline. However, it declined nearly 37 per cent towards March-end, leaving 48 per cent of the scrips in the red (down 40-80 per cent). The recovery was equally sharp with overall gains of 37.2 per cent.

The year-to-date performance of mid-caps is no different from that of large-caps. The top performers include mostly pharma stocks such as Bayer CropScience (54 per cent) and Ajanta Pharma (49.3 per cent). Almost two-third stocks in this space are trading below their five-year historic PE ratio. Shriram Transport Finance Company and Oil India are trading 50 per cent below their five-year median PE ratios.

Small cap: Show-stopper

The bottom 15 per cent, or the small-cap, segment was the worst performer of 2019. It has fallen the least, 7.3 per cent year to-date. However, it put on a power-packed show in the June quarter with double-digit outperformance over the 30-stock Sensex. The Sensex rose 19 per cent while the small-cap index rose 29 per cent during the period.

Close to 27 per cent, or 191 stocks, in the index are up since the start of 2020. Moreover, prices of around 10 small-cap stocks have risen over 100 per cent during the period. This includes Opto Circuits (India) and Sintex Industries. On the valuation front, almost all small-cap stocks are available at a discount to their five-year average multiples.

Jain of Principal Asset Management says excess liquidity is behind the performance of mid-cap and small-cap indices. "This is likely the result of liquidity which flooded markets globally as central banks increased the size of their balance sheets to support economies and face stresses caused by the lockdown and collapse of demand. This liquidity has driven up prices of risk assets globally. The outperformance of mid-cap and small-cap stocks is likely a part of that picture." The sharp fall in markets at the end of March had made them cheap and amenable to a bounce, he says.

The performance of small-cap and mid-cap stocks has been better in 2020 compared to 2019 as these were beaten down badly. Then, as momentum picked up, participation by non-institutional investors rose. Around six lakh new demat accounts each were opened with the central depository services in March and April. "The cumulative fall in these stocks (including the March 2020 fall) seemed more than required and attracted value buying. Moreover, young new-to-market investors and traders signed up with brokerages and started dabbling in small-cap and mid-cap stocks to make a quick buck," says Jasani of HDFC Securities.

The Penny Party

Penny stocks, or scrips that trade at less than Rs 10, too jumped on the bull-market bandwagon. While over a four-fifth of them were in the red in the past year or so, just 5 per cent stocks in this lot have not recovered since the steep fall of March. The advance to decline ratio of the market shot up sharply in early April and first week of June. Moving forward, Jasani is cautious as in any bull run, the momentum passes from large-caps to small-caps and mid-caps in the next stage, before there is reversal in trend. "The fact that a lot of penny stocks have started participating in the run-up is sign of an impending reversal in trend," he says.

There are many things that may upend this recovery and keep markets volatile in the near term. Economic revival is expected to be gradual and uncertain due to caution on part of consumers, weak corporate balance sheets and threat of second wave of coronavirus infection.

Jain of Principal Asset Management says markets may favour companies expected to emerge stronger from the crisis due to dominant position in their industry, balance sheet strength and early resumption of operations. "As the Covid issue settles, the economy gradually moves towards normalcy and earnings recover in FY22, the markets may move up steadily in the next couple of years," he says.

No matter how the market moves, experts say that rather than tracking the benchmark indices, one should go for value buying and take advantage of volatility instead of shying away from it.