Small and mid-cap rally: Why retail investors need to be cautious

With earnings growth yet to justify the high valuations of these stocks, they seem to be in a bubble territory

After the depressing fall in the first two months of the current year, the equity market has been rewarding for shareholders. From its low point in February 2016 of 22,494, BSE Sensex has given a return of nearly 25% till date.

But the real action was in the mid-cap and small-cap space. BSE Midcap index has given a return of 36% over the same period. Many smaller stocks have given multi-bagger returns over the last few months.

Though the returns by these stocks look impressive, a cause for concern is increasing differential between the valuation of frontline and mid-cap stocks. A report by Bank of America Merrill Lynch points out that the premium at which mid-cap stocks trade over their frontline peers is at the highest level, even surpassing the peak premium of 2008 — just before the financial meltdown.

The reason generally cited for the strong performance of mid-cap stocks is their proximity to the Indian economy or to use a market parlance, they are domestic plays. Bigger companies, on the other hand, have a large portion of their revenues coming in from global markets. With the on-going global slowdown, the bigger Indian companies have been affected. This is captured in months of steady decline in exports.

Though the controversial GDP data print is showing steady growth, the same is not reflecting in corporate numbers, especially for smaller ‘domestic plays’. Vidya Bala, Head of mutual fund research at Fundsindia.com pointed out earnings of midcap stocks have fallen by 5.5% over the last three years, but the mid cap index has nearly doubled during this period.

Fundamentals are yet to catch up with the market, especially in the case of small-cap stocks. Sensex is trading at 17.5 times one-year forward earnings but the BSE mid-cap index, as per Bloomberg data is trading at 33 times, nearly twice as much as the Sensex. But the real shocking number is in the valuation of small-cap stocks, which trade at more than 65 times or nearly four times as expensive as frontline stocks.

Unless the smaller companies start showing very strong growth to justify their valuations, they are clearly in bubble territory.

Market participants have taken notice of the high valuations of smaller companies. Mutual fund DSP Blackrock has decided to restrict flows into top performing small-cap schemes, according to this report. The fund house will not accept investment of more than Rs 1 lakh per investor daily in its Micro Cap Fund. Explaining the logic, its fund manager Vinit Sambre pointed out that valuations in mid and small-cap space has moved up, the number of opportunities in the micro-cap space have shrunk.

Smaller companies are relatively illiquid and do not require too much of buying or selling to show sharp movement. 
 

It is thus all the more important to be cautious, especially since headwind of low international oil prices and foreign currency withdrawal through closing of FCNR (B) window is in front of us.

It is generally the retail investors who gets sucked into the smaller companies and buys them without looking at their financial history or valuations. They end up buying a story and hoping that it plays out as told to them. But a valuation of 65 times captures at least three years of 50% growth to come down to the upper band of frontline stock valuation. That’s a lot of hope built up already in the valuations.