Sell smallcap, midcap stocks; markets will offer buy-on-dip opportunities: UBS

The sharp run in the Indian smallcap and midcap stocks in the last few months has made analysts at UBS cautious on these two market segments. In a recent note, they suggested investor’s book profit in small-and mid-cap stocks and stick to the safety of their large-cap peers.

A sustained bull market rally in equities, earnings growth catch-up with large-caps, and strong momentum in institutional equity inflows, UBS said, have widened the outperformance of small-cap and midcap companies in India over large-caps in the last couple of years. 

During this period, small-caps and midcaps, it suggests, have significantly re-rated while the valuation differentials versus large-caps have also steepened towards historical peak levels.

On an absolute basis, the 12-month forward price-earnings (P/E) of the Nifty Midcap 100 index has risen to 30x (2x in last ten years), UBS said, and is more than 2 standard deviations above its ten-year average, while the 12-month forward P/E of Nifty Smallcap 100 index has risen to 20.3x (1.8x in last ten years), closer to 2 standard deviations above its ten-year average.

“On a relative basis, large-cap valuation differentials currently stand above +2 standard deviations for mid-caps and above +1 standard deviation for small-cap stocks. Following this rally, we turn cautious on smallcap and midcap stocks, as we believe that current valuations are running ahead of fundamentals for these companies. We recommend investors take profits in small-cap and mid-cap stocks and increase exposure to large-caps,” wrote Premal Kamdar of UBS in a recent note.

Large-caps stocks, on the other hand, UBS said, are relatively better placed due to superior earnings growth as well as higher profitability (better ROE versus small-and midcaps), and remain relatively less sensitive to higher oil prices. 

Midcap, largecap valuation

The key risk to this view, UBS cautions, is the sustenance of higher equity inflows into small-and mid-caps and stronger earnings growth despite higher crude oil prices.

Strong run

At the bourses, meanwhile, calendar year 2023 (CY23) was a stupendous year for the Indian midcap and small-cap universe. 

The Nifty Smallcap 250 index surged 48.1 per cent in CY23 as compared to 43.7 per cent rise in the Nifty Midcap 150 index and 20 per cent gain in the Nifty50 index, ACE Equity data shows.

And this bull-run in the mid-and small-cap stocks has continued well into CY24 with the NSE Nifty Midcap 150 index hitting a record high of 19,222.60 in intra-day trades last week. The index breached its previous high of 19,064 hit on May 3, 2024. 

What to buy and sell?

Lok Sabha 2024 election-related volatility amid rich valuations, UBS believes, is likely to keep the market sentiment in check. However, a market correction, if any, it said, is unlikely to be deep and prolonged as the combination of resilient macro, healthy corporate earnings, and robust equity inflows should limit downside.

“The markets will offer buy-on-dip opportunities, in our view. We expect low-teen upside for the Nifty 50 by March 2025. Key risks for Indian markets are elections (political instability leads to higher volatility), a delay in the start of the US rate cut cycle (higher-for-longer interest rates), and geopolitical shocks (surge in crude oil prices),” Kamdar wrote.

Among sectors, UBS prefers domestic-linked sectors such as automobiles, consumer durables, industrials / infrastructure, utilities, and real estate. 

These sectors, UBS said, provide good long-term growth visibility led by strong order books, stable margins, and healthy balance sheets, over export-linked sectors (like IT, chemicals, and metals and mining) that are still vulnerable to uncertainty in the global growth outlook.