Big risks in small stocks

Prices are moving ahead of fundamentals

The stock market has seen a sharp runup in 2023 with major indices such as the Nifty rising to new record highs. But a far stronger bull run has occurred in the smallcaps and midcaps. Since January, the Nifty is up a little over 10 per cent, while the Nifty Midcap is up 27 per cent and the Smallcap has increased 28 per cent. The rally in smaller stocks has, in fact, been so strong that there is concern of overheating. It is hard to justify this rise in terms of fundamentals because the pace of earnings growth has slowed. In terms of price-to-earnings (PE), the Nifty is now trading at PE of 23-24, while the Midcap is doing so at PE 24-25, and the Smallcap index is trading at PE of 25-26. The pace of earnings growth in Q1FY24 does not warrant such high valuations.

The rally has occurred because this has been one of those periods when institutions and retail investors have been net buyers. In the calendar year so far, foreign portfolio investors (FPIs) have bought a net Rs 1.3 trillion, while domestic institutions have bought stocks worth Rs 1.12 trillion and equity mutual funds have received inflows of Rs 95,000 crore (until end-August). The rally in smaller stocks has been driven by a combination of retail interest and equity-fund buying, which in turn has also been driven by the strong retail inflows. The macroeconomic situation and geopolitical trends are not very propitious. While there’s the promise of growth, there’s also intractable domestic inflation. This makes it unlikely that the central bank will ease monetary policy, and that hope was one of the causes for optimism. The Ukraine war continues and fuel prices have spiked again, which always places stress on India’s trade account.

On the plus side, there’s been some improvement in consumption demand, going by sales of automobiles and two-wheelers, and there’s been some private-sector capex, which should back government spending on the infrastructure and defence front. The revival in demand doesn’t seem very broad-based yet and the monsoon has been patchy. The last few weeks have seen savvy investors and institutions repeatedly warning that the market was overheating. FPIs have also started booking profits by selling into the rally. But retail investors carried on buying with a focus on smaller stocks until the last two sessions when they started selling.

Dabbling in small companies can be a very rewarding exercise but it is also far more risky than buying into larger stocks, where there is more institutional exposure. For one thing, institutions do their research and there is far better quality of information available about larger companies. Also, large institutional stakes put a floor on the share price. In terms of fundamentals, a larger company also has more resources to ride out a possible downturn in the business cycle. As a result, while prices can zoom in small companies, price corrections can also be very steep. Retail investors tend to be driven more by sentiment than by research. Many of them are also players on margin and a relatively small correction can lead to their capital being wiped out. In the absence of deep pockets and given the sentiment-driven nature of smallcap buying, a deep correction is possibly on the cards in this segment of the market.