2 reasons behind rally in midcap, smallcap shares & why investors are nervous now

Strong narratives over earnings growth translated into higher delivery volumes and it is this higher delivery in low free-float midcap and smallcap companies that generated substantial returns in midcap and smallcap pockets, Kotak Institutional Equities said in its latest strategy note. The brokerage said a sharp price correction seen in a section of such stocks last week shows the nervousness of the market with respect to ‘owning’ midcap and small-cap stocks after such lofty returns. Narratives would need to be converted to reality for stocks to hold gains, it said.

The domestic brokerage refrained from drawing any conclusion but cited a similarity of the prevailing trend with midcap peak of 2017, wherein a when a number of midcap shares delivered phenomenal returns, with stocks having lower free-float outperforming peers.

Following a strong show in 2017, Nifty Midcap-100 index  declined 15 per cent in 2018 and most companies in the top quartile of performance saw significant value erosion, Kotak cited.

Kotak said the market expectations around the future returns of most midcap and smallcap stocks reflect a great deal of optimism, as stock returns have far exceeded improvement in their fundamentals.

"The sharp price correction seen last week in a section of these stocks shows the nervousness of the market with respect to ‘owning’ mid- and small-cap. stocks after such lofty returns. The outperforming companies may need to show greater improvement in their financial and operating performance for their recent strong stock performance to sustain," it said.

Kotak said a large increase in flows into midcap and smallcap mutual funds may reflect investors’ expectations of high returns and in turn, may have helped sustain the surge in delivery volumes over this period. It however noted that delivery value has seen a sharp decline in October 2023 against September 2023. This is even as large cap stocks have not shown any meaningful deviations in their delivery volumes, the domestic brokerage said.

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