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Only investors with a long horizon should enter mid- and small-cap segment

After the outperformance of the past three years, they should be prepared for modest returns in the near term

Bs_logoBSE Sensex
Sanjay Kumar SinghKarthik Jerome New Delhi
5 min read Last Updated : Feb 26 2023 | 9:36 PM IST
The S&P BSE Midcap Index and the S&P BSE Smallcap Index have given returns of -4.3 per cent and -4.5 per cent, respectively, over the past three months. The Sensex has fared slightly better (-3.3 per cent). Some market experts are currently recommending a complete exit from mid-cap stocks as they tend to underperform during times when the Reserve Bank of India (RBI) is withdrawing liquidity. Should you take such a drastic step?

Myriad headwinds

Earnings downgrade: The mid- and small-cap segments face several headwinds currently. Says Anupam Tiwari, equity fund manager, Axis Mutual Fund: “This segment faces potential earnings downgrades due to margin pressure and lower sales growth.”

Valuation hurdle: Valuations are another issue. “Mid-caps continue to have higher valuation than trend levels, though this has corrected in the recent past,” says Janakiraman R, senior vice president & portfolio manager, emerging markets equity-India, Franklin Templeton. He adds that the outperformance of mid- and small-cap stocks vis-a-vis large caps over the past three years is a handicap that will require some time to overcome.

Inventory cycle reset: Supply chains were affected during the pandemic. To ensure sufficient supplies and for protection against rising input costs, companies stocked massive amounts of raw materials. Their customers did the same. This led to volume growth and margin expansion (inventory gains contributed partly to this). According to Jatin Khemani, managing partner and chief investment officer, Stalwart Investment Advisors LLP, a Securities and Exchange Board of India-registered independent equity research firm, “The situation has reversed completely now. There is a slowdown at the end-consumer level due to recessionary conditions in key international markets and high inflation in the domestic market. The channel is focusing on clearing its inventory first, leading to reduced offtake from manufacturers, and hence a drop in their volumes. The raw material price trend too has reversed leading to inventory losses for those who continued to maintain high stock,” says Khemani. He adds that those who expanded capacity have been hurt more due to the additional overheads, while there has been no uptick in volumes yet. Mid- and small-cap players, too, have been hurt by this trend.

Positives on the horizon

Many experts remain optimistic on the medium- to long-term prospects of mid- and small-caps.

Recovery in capex, discretionary spending: Janakiraman says a nascent recovery in the capex cycle points towards an acceleration in national growth over the medium term.

The asset quality of retail and high yield credit is improving, which indicates that the repair of balance sheets of households, impacted by Covid disruptions, is nearing completion. Janakiraman expects private discretionary spending to start growing again soon.

Manufacturing sector growth: The China +1 opportunity in manufacturing, coupled with targeted production-linked incentive (PLI) schemes, is expected to enable this sector to grow at a faster pace than in the previous decade.

Impact of rising rates factored in: Amid rising interest rates, the profitability of mid- and small-cap companies is affected more, as their cost of capital (credit spreads) tends to be higher than that of large-caps.

However, some experts are optimistic that rising cost of capital may not hit the mid- and small-cap segment hard this time. “Most companies have gone through deleveraging in the last seven years and don’t have much debt on their balance sheets. Companies undertaking capex are relying more on internal accruals than on borrowed capital,” says Rajesh Cheruvu, managing director and chief investment officer, LGT Wealth India. Moreover, the bulk of rate hikes are behind us. “The RBI may at best hike the repo rate by another 25-40 basis points, and these hikes are already priced in,” says Cheruvu.


 
According to Sonam Srivastava, founder and CEO, Wright Research, “When inflation begins to soften and the market begins to bet on rate cuts, that is when the recovery in mid- and small-caps will begin.”

Formalisation: Mid- and small-caps are also expected to benefit from the growing formalisation of the economy, which accelerated during the pandemic.

Finally, Srivastava is of the view that the earnings downgrade cycle is nearing the bottom.

Not the time to exit

Volatility may continue over the next three-six months. “However, we are optimistic on mid-caps from an 18-24 months perspective,” says Cheruvu. He suggests investors should not exit mid-cap stocks. As for small-cap stocks, he recommends taking stock-specific calls.

Investors should also use the current period of underperformance to buy quality stocks and to accumulate mutual fund units at a lower average price.

Investors should adopt an asset allocation approach when investing in the mid- and the small-cap segment. “Only moderate to aggressive investors should participate in them,” says Cheruvu.

Direct stock investors should exit both highly leveraged companies and those trading at high valuations. They should also steer clear of any company whose management has a dodgy reputation.

Stick to skilled fund managers

According to Cheruvu, funds with large assets under management may find it difficult to outperform, especially in the small-cap segment. Srivastava suggests that stock selection plays an important role in these segments, so investors must look closely at the fund manager’s track record.

Instead of trying to time the market with lump sum investments, investors should invest regularly via the systematic investment plan (SIP) route. Tiwari suggests investing  with a six-eight-year horizon.

Adds Janakiraman: “Investors will have a high probability of achieving a satisfactory outcome if they combine realistic return expectations with a long time frame.”

Topics :mid-capssmall-capsS&P BSE Sensexstock market investingInvestmentAxis Mutual Fund

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