Mumbai: After a blockbuster rally last year, smallcap and midcap stocks lost some of their sheen in 2018 as investors grappled with the effects of steep valuations, macro headwinds, moderating domestic flows and changes in regulatory norms—all of that in the midst of a liquidity crisis.

The BSE midcap index slipped 14.42% while the smallcap index slid 24% in contrast to a 5% rise in the benchmark Sensex this year so far. This is the steepest decline of both midcap and smallcap indexes in the last seven years. Last year, midcap and smallcap indices were up 48% and 59%, respectively, while the Sensex gained 28%.

According to Rusmik Oza, senior vice-president, head of fundamental research, Kotak Securities Ltd, the main reason for the fall was overvaluation of both the indices.

“Due to fear of introduction of LTCG tax, these indices started to correct from the end of January. Post introduction of LTCG, the gap of overvaluation with the Sensex/Nifty started narrowing. The deep losses incurred by domestic HNIs (high net worth individuals) and retail investors in the midcap and smallcap stocks led to risk aversion in these segments which in turn led to a further fall in these indices when the Nifty corrected from 11,700 to around 10,000 levels," he added.

Other analysts such as Deepak Jasani and Naveen Kulkarni point to regulatory changes adopted by the exchanges and the Securities and Exchange Board of India (Sebi), which, they say, had the effect of disincentivizing traders from buying or holding on to the shares.

“The reclassification of midcap and smallcap funds by Sebi led to a significant realignment of funds according to the new norms. This reduced the demand for midcap and smallcap funds. Thus multiple intrinsic challenges in the backdrop of the rising cost of funds and declining global liquidity led to the sharp fall in midcap and smallcap indices," said Naveen Kulkarni, head of research, Reliance Securities.

Despite a sharp selloff this year, midcap stocks have not become cheap yet as these companies are still trading at a premium to their largecap peers. However, the valuation gap between the BSE midcap index and Sensex is gradually narrowing. At current levels, the premium of the BSE midcap index to Sensex is at 6.6%. According to Bloomberg, the BSE midcap index is trading at 18.97 times based on FY19 earnings and at 22.39 times for FY20. In contrast, the Sensex is at 17.78 one-year forward PE 20.97 for next fiscal year.

According to Kulkarni, midcap stocks are still at a premium to largecap stocks because they are dominated by growth stocks while the Sensex has a healthy contribution of value stocks which trade at significant discounts to growth stocks. “Thus the mix of stocks is the primary reason for the premium valuation," he added.

Analysts, however, say that due to underperformance of stocks, valuations in the midcap space have come back to more realistic levels. They expect volatility in midcap and smallcap stocks to continue in 2019. Gautam Duggad, head of research, institutional equities, Motilal Oswal Securities sees a gradual recovery taking place already in midcaps but said the first half of 2019 will be marked by elevated volatility due to general elections, due by May.

Kulkarni agrees midcaps and smallcaps tend to struggle during times of volatility. “The first half of 2019 is likely to see significant volatility, and therefore, midcaps and smallcaps are unlikely to perform. However, the second half of 2019 volatility is likely to reduce which would be favourable for midcaps and smallcaps stocks that may start outperforming. The key factors to watch for next year will be the nominal GDP growth rate and volatility," he said. However, Oza expects the mid- and smallcap indices to outperform in 2019. According to him, the factors to watch next year are government policies, benign raw material costs, which would help improve margins, and political stability.

Ashwin Ramarathinam contributed to the story.

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