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Home >Markets >Mark To Market >This dream rally in mid-caps and small-caps is now turning frothy

Stocks in the mid- and small-cap segments continue their relentless rally, meaningfully overtaking large-sized peers in terms of returns. These companies have benefited from the liquidity-driven rally, wherein investors are increasingly chasing stocks irrespective of fundamentals.

An analysis by Motilal Oswal Financial Services Ltd shows that the NSE Midcap 100 and NSE Smallcap 100 indices have generated positive monthly returns for the past 13 and eight months, respectively. In this span, the former has gained around 102%, while the latter rose 67%. As a result, Nifty’s underperformance versus the mid-cap index on a 12-month rolling basis is at the highest level since the great financial crisis of 2009.

Ripe for a fall
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Ripe for a fall

With that, the mid- and small-cap stocks have become dearer than largecaps. For the first time in nearly a decade, the Nifty Smallcap index is trading at a premium to Nifty and valuations of Nifty Midcap index are on a par with Nifty, added the Motilal Oswal report.

But following the mouth-watering returns within a short span, analysts said it is time to be cautious as the stocks may have run ahead of themselves ignoring some key downside risks. “The current mid-cap rally has turned a little frothy. Low-quality names without any business growth prospects have started to fly. Our analysis shows that top gainers in the midcap and small-cap space are among the worst quality of companies in terms of RoCE and our accounting quality framework," said Dhiraj Agarwal, co-head, equities, Ambit Capital. RoCE is short for return on capital employed.

“These stocks have rallied hard and many of them are just based on tips with no fundamental backing. This is true even for a handful of stocks in the large-cap space, but it is more pronounced in the mid-cap and small-cap segments," he added.

Another disappointment for investors in these stocks could come from earnings. An Edelweiss Securities Ltd analysis shows that the one-year forward earnings per share (EPS) of the Nifty50 index is estimated to grow from 745 in FY22 to 848 in FY23. EPS of the Nifty Midcap and Nifty Smallcap are seen improving sharply from 1,233 and 416 in FY22 to 1,504 and 553, respectively, in FY23. Clearly, earnings growth estimates are higher for the smaller firms.

“The sharp upward revision in corporate earnings estimates is driven by expectations that cash-flow improvements and deleveraging seen in FY21 on the back of cost-cutting could continue. But it looks like positive investor sentiment has also rubbed off on earnings expectations for mid-caps and small-caps. There isn’t much scope for cost rationalization for even large companies and rising input cost pressures could make it worse for smaller companies. Given their inability to absorb costs, it would put mid-caps and small-caps in a tight spot. Investors need to soon realize this," said an analyst with a domestic brokerage house requesting anonymity.

Put simply, rosy earnings growth projections are at risk.

Noted that with business normalcy returning, large companies have indicated that discretionary expenses related to travel and advertisements are making a meaningful comeback. Costs of key inputs across industries have spiked, and additional cost pressure amid weak pricing power could mean poor operating performance.

According to Ambit Capital’s Agarwal, whenever equities correct, poor-quality companies among mid-caps and small-caps will fall much harder.

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