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Despite Correction, Froth Yet To Settle On Small And Mid-Cap Stocks

SEBI has issued warnings regarding excessive exuberance in small- and mid-cap stocks, even urging mutual funds with such portfolios to conduct stress tests.

By The Core Team
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In March, the Indian stock market recorded a significant correction in mid-cap and small-cap stocks. The benchmark Nifty 50 returns for the month have also been subdued. This downward pressure on mid-cap and small-cap indices follows concerns raised by the market regulator, the Securities and Exchange Board of India (SEBI), regarding the accumulation of ‘froth’ in this segment.

“I believe that the valuations are extremely stretched. It needed the regulator to come and talk about it to ensure that sanity returns to markets. I wouldn't say it was a huge correction, it was a decent correction because most of these stocks had become multi-baggers, in a very short while,” veteran market analyst Ambareesh Baliga told The Core.

Small-cap stocks are typically characterised by a market capitalisation (mcap) of up to Rs 5,000 crore, while mid-cap stocks typically have mcap within the range of Rs 5,000 crore to Rs 20,000 crore. Cautioning against over-valuation in the segment, SEBI chief Madhabi Puri Buch recently said that the exceptionally high valuations seen in these market segments, often deemed as "off the charts", were primarily due to the presence of "froth" in small and mid-cap stocks. 

Why Is SEBI Worried?

SEBI has issued warnings regarding excessive exuberance, even urging mutual funds with small- and mid-cap portfolios to conduct stress tests to assess the potential impact if investors were to suddenly redeem their units. Financial services company Jefferies Group has characterised the recent correction in small-cap and mid-cap stocks as healthy, noting that it doesn't signify a broader meltdown.

Since the start of 2023, the Nifty small-cap 100 and mid-cap 100 indices have surged by 58% and 54% respectively, surpassing the 23% increase in the benchmark Nifty 50 index. “The valuations are at 25%-30% of that of Nifty. The selling pressure would continue in the near term. This correction provides investors with the opportunity to accumulate good quality stocks,” Sneha Poddar, AVP Research, Broking & Distribution, Motilal Oswal Financial Services, told The Core. 

SEBI cautioned against price manipulation in the small and medium enterprises segment. Buch had also indicated that SEBI was ready to reconsider regulations mandating small- and mid-cap funds to allocate 65% of their assets into these stocks.

After the warning, the Association of Mutual Funds in India (AMFI) instructed mutual funds to conduct stress tests every 15 days and disclose the results starting from March 15. This directive potentially led to a reshuffling of mutual funds' small-cap and mid-cap portfolios. Previously, SEBI had asked asset managers to provide investors with more information regarding the risks associated with small- and mid-cap funds.

“A couple of sectors which have been in vogue in the last 18 months and more, I would say defence and railways. The markets have discounted the huge amount of order flows, which have flown to these larger companies in this space. Some of these companies have taken in orders, which are about six to eight times their current revenue. And that's huge by any standards,” Baliga said.

Why Are They Overvalued?

Valuing such companies at six to eight times their current revenue can make the situation increasingly strained. This begs the question of whether such companies can effectively manage fresh order flows given the quality of their existing order book and whether they have the financial capability to do so.

According to Baliga, there is little discussion regarding execution risks and that it is unrealistic to expect flawless execution of all these orders. “I don't think it's possible. I don't think anyone really is in a position to expand the capacity 3x or 4x to meet the sort of order flows which are there because what is said and done, there is a limitation to capacity expansion,” he said.

In the fiscal year 2023-24, the proportion of net inflows into equity funds directed towards focused mid- and small-cap mutual funds has surged to 42%, a significant increase from 29% in the previous fiscal year 2022-23, and notably higher than the 16% recorded two years prior. 

“The ground situation, as far as the sectors are concerned, or even the specific stocks are concerned, didn't change very much. But still, they became multi-baggers. So clearly, there was a lot of froth. And I don't believe that the froth has cleared yet. Typically, wherever we had seen corrections in the past,” Baliga said.

 

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