Midcap, smallcap stocks: What is driving the rally and should you be cautious now?

Against a 9 per cent rise in the BSE Sensex in 2023 so far, midcap and smallcap indices have rallied 28-31 per cent during the same period. Brokerages such as Kotak Institutional Equities said the primary driver of the rally 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 said.

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 said 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.

Kotak said 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 Securities, meanwhile, 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, Elara said, 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

"Given that the valuations are not cheap, we expect all the incremental flows to look for names that are cheaper on a growth-adjusted basis," it said. 

Elara 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.

 

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