Unusual moves: Investors should tread carefully in smallcaps space

The stock-market correction of the past two months has some unusual aspects. It has been driven by sustained selling by foreign portfolio investors (FPIs) while domestic institutions and retail investors have stayed bullish. Another unusual feature is that smallcaps and midcaps have displayed more defensive strength than largecaps. While the Nifty is down 6 per cent from its September highs, the smallcaps index is down only 2.5 per cent. The smallcaps have also easily outperformed the Nifty in the bull run that occurred till September, gaining 38 per cent between January and September, while the Nifty rose 26 per cent. Outperformance by smaller stocks during a bull run is common. But defensive strength in a downturn is rare. A case can be made that this indicates a shift in the way the Indian economy is performing.

 

The correction being driven by FPI selling is one reason why the smallcaps have done relatively well. FPIs have zero exposure to small stocks. Their attitudes are certainly influenced by India’s fundamentals, and they would have been disappointed by the weak second-quarter results. FPIs also need to rebalance the China weighting in their emerging-markets portfolio and they are second-guessing the likely policy decisions of the incoming Donald Trump administration in the US. However, while the largecaps have delivered weak performances in Q2FY25, smaller stocks enjoyed much more growth. Part of this is the arithmetical phenomenon of growth on relatively low bases — it is much easier for a small company to grow quickly. However, it is also true that the “hot” Indian sectors that have seen fast growth over the past few years are under-represented in the Nifty, or not represented at all in many cases.

 

The big areas of growth include green energy, defence, health care services, several types of niche manufacturing plays, infrastructure-related plays, consumer technologies, and retail financial services, including newly listed areas like wealth management. Other sunrise sectors include electronics-manufacturing services, contract drug manufacturing, recycling electronic waste, making smart meters, and data centres. These are all dominated by small companies, which by definition are in sunrise sectors and are companies that have not been in business long enough to generate a really large top line and bottom line. Again, almost by definition, fast growth off relatively low bases is possible in these sectors.

 

Since this growth isn’t reflected at all in the Nifty, it’s rational for big institutional players such as FPIs to be conservative or bearish. Indeed, except for a few mutual funds, domestic institutional coverage of smallcaps is also quite low. It is likely that some smart retail investors who have done their due diligence have generated higher capital gains than the big players because they have invested in small, high-growth businesses. While there is a fundamental argument about the arithmetic of low bases generating high growth, it is also true that the midcap and smallcap space has historically elevated valuations. The Nifty Midcap 100 is trading at 32 times its forward earnings (FY25), against its 10-year average price-to earnings (PE) of 17. The Nifty Smallcap 100 is trading at a PE of 24, against its 10-year forward average of 16-17. While small companies can grow faster than large ones, if overall growth does slow, small companies also have fewer resources to ride out the downturns. The gross domestic product data and Q2FY25 corporate results do suggest a slowdown. While there are surely pockets of value and potential multibaggers in the smallcap space, investors should be cautious due to the elevated valuations in this part of the market.