Mid-, smallcap stocks overheated; rally an irrational exuberance: Analysts

The recent rally in the small-and mid-cap (SMID) stocks is not backed by fundamentals and is a case of irrational exuberance, said analysts at Kotak Institutional Equities in a recent report. Fundamentals of most companies, they said, have in fact worsened over the last few months. Yet, some analysts expect the bull-run in these stocks to continue amid intermittent corrections.

"There is no meaningful change in the fundamentals of most (mid, smallcap) companies; in fact, they have worsened in many cases. 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," wrote Sanjeev Prasad, co-head of Kotak Institutional Equities, in a note co-authored with Anindya Bhowmik and Sunita Baldawa.

In June and August, too, Prasad had cautioned against the meteoric rise in the stocks of these two segments and suggested investors remain cautious as regards these counters.

At the bourses, meanwhile, the S&P SBE Smallcap index has given a stellar return – rising over 32 per cent in 2023, while the S&P BSE Midcap index has surged around 29 per cent during this period. The S&P BSE Sensex, on the other hand, has moved up close to 10 per cent.

Most of the traditional favorite mid-cap stocks of institutional investors in the broader ‘consumption’ sector, Prasad said in his latest note, have been large laggards in the ongoing mid-cap rally, given weak consumption demand in general. The valuations of these companies, however, have stayed high, or gone to historical-high levels due to earnings cuts.

Among individual stocks from these two segments, Jai Balaji Industries has zoomed over 500 per cent thus far in 2023. Zen Technologies, Jupiter Wagons, Titagarh Railsystems, Jindal Saw, Aurionpro Solutions, Genus Power Infrastructures and Patel Engineering have jumped between 220 per cent and 350 per cent, data shows.

More leg room

Despite the run, analysts believe SMID stocks still have more room to fly. In the past five years, Nifty Midcap Index, according to analysts at Elara Capital, has outperformed Nifty 50 Index by around 5 percentage points and Nifty Smallcap Index has underperformed by nearly 2 percentage points, annualised.

For the 5-year outperformance over Nifty to catch up with 10-year outperformance, midcap index needs to rally over 10 per cent and Smallcap index more than 20 per cent, the note said.

"Though SMID CY23 outperformance may likely indicate an overheating and an approximation to the peak performance, but per our analysis, this recent large outperformance is only a swing-back from the extreme under-performance seen through 2018-2022. There is still room to catch up to the long-term outperformance rate, especially for small-cap stocks," wrote Bino Pathiparampil, Aditya Jaiswal and Keval Shah of Elara Capital in a recent note.

The rally in SMID stocks, according to analysts at HSBC, has in part been fueled by very strong fund inflows into domestic midcap and small cap funds (over 30 per cent of monthly gross inflows versus five-year average of 20 per cent), and index valuation has expanded – at 24.8x forward PE (4 per cent above its five-year mean and 15 per cent above its long-term mean),.

"Midcaps have rallied hard, a key symptom of the bull market, and our analysis of cycles suggests we are still midway. Midcap valuation premium at 34 per cent is inching closer to cycle peak of around 40 per cent, but broader market bullish phases can still last. Rising crude, food inflation in the near term are risks to watch out for," wrote Herald van der Linde, Head of Equity Strategy for Asia Pacific at HSBC in a coauthored note with Amit Sachdeva and Anurag Dayal.