Capital gains tax, valuation woes: No stopping the mid, smallcap bulls

Mid-cap, small-cap stocks: Higher rates of long-term and short-term capital gains tax (LTCG, STCG) introduced in Budget 2024 and valuation concerns in a lot of stocks that comprise mid, small-cap stocks have not been a deterrent for the bulls in these two segments.

From the July 23 Budget 2024-day low, the midcap and the smallcap indices on the BSE have seen a surge of over 6 per cent and 7 per cent respectively, shows ACE Equity data. The up move has been higher than the 2.5 per cent rise in the S&P BSE Sensex during this period.

 

On its part, the Budget 2024 has hiked LTCG and STCG taxes on sale of shares from 10 per cent to 12.5 per cent, and from 15 per cent to 20 per cent, respectively.

Meanwhile, analysts have been cautious on these two segments – a favourite of retail investors – citing valuation concerns since quite some time now. Investors, it seems, have not heeded to their word of caution yet.

Why are the mid, smallcap stocks rallying?

The disconnect between earnings and market prices in the broader market, according to V K Vijayakumar, chief investment strategist at Geojit Financial Services, has been driven by the sustained fund flows into these segments and irrationally enthusiastic retail buying.

"Market history tells us that irrational exuberance can last longer than seasoned experts think. But it is always better to err on the side of caution. Buy on dips strategy has been working throughout this bull-run. Investors can utilise the dips to buy fairly valued large-caps," he suggests.

At the bourses, meanwhile, stocks of MTNL, Antony Waste Handling, MMTC, IFCI, PG Electroplast, Hindustan Construction Company, Ashoka Buildcon, Nuvama Wealth Management, Arvind Smartspaces and Protean e-Gov Technologies have surged up to 39 per cent from their respective Budget 2024-day lows.

While the Sensex still trades at a reasonable trailing price-to-earnings (PE) at 24.3, the BSE Small-cap and BSE Mid-cap indices trade at stretched valuations of around 36.4x and 33x, respectively.

Overall market-cap build up, extremely stretched valuation of many individual stocks in the small-and mid-cap (SMC) space and drying up of liquidity from the secondary markets due to the ongoing and upcoming initial public offers (IPOs) are the top risks to the markets, according to market experts.

"History proves the point that SMC segment invariably falls very badly – without giving any ample time to rejig equity asset class - once in 3 or maximum 4 years and brings in some balance between large-cap versus SMC valuations. That time is approaching fast," said G Chokkalingam, founder and head of research at Equinomics Research.

Earnings growth of India Inc

Earnings growth of India Inc, especially in the mid-and small-cap universe, according to analysts at Bernstein, has not kept pace with the sharp rise in the stock prices. Sectors with decent earnings upgrades, they said, show a disproportionately high movement in their stock prices - suggesting an optimistic overpricing.

"A stark difference is seen in the top 100 and bottom 100 of our NSE200 stocks, with FY25 earnings of the top 100 almost flat at around 1 per cent, while the bottom 100 declined by 2.6 per cent over April & May. This has led to nearly half the midcap 150 stocks trading at a one-year forward PE of 40x or more. For large caps, this number is at 41 per cent," wrote Venugopal Garre, managing director at Bernstein in a recent coauthored note with Nikhil Arela in a recent note.