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(Photo: ANI)
(Photo: ANI)

BSE Smallcap at 17-month high, investors queue up on liquidity hopes

  • Investors are expecting a strong rally in small- and mid-cap stocks led by mutual fund buying after Sebi's Friday order
  • However, analysts at BofA Securities feel that hopes of a small- and mid-cap rally on the back of any rotation are likely to be disappointed

Buoyed by expectations of stronger liquidity flow, BSE Smallcap index climbed 4%, hitting 17-month high on Monday. BSE Midcap index also rallied nearly 2% outpacing benchmarks. The BSE Sensex ended at 38,756.63, down 97.92 points or 0.25. The 50-share index Nifty ended at 11,440.05, down 24.40 points or 0.21%.

Investors are expecting a strong rally in small- and mid-cap stocks led by mutual fund buying after Securities and Exchange Board of India (Sebi) made it mandatory for multi-cap schemes to allocate 25% of their portfolio to large-, mid- and small-cap stocks each. According to analysts flows may gravitate towards a handful of quality stocks in mid- and small-cap sectors as investors also factor in the fact that during bad market cycles, when drawdowns are high, superior quality holdings will protect the downside.

However, analysts at BofA Securities feel that hopes of a small- and mid-cap rally on the back of any rotation are likely to be disappointed. “We continue to prefer large stable companies in the current stressed business environment…Further, assuming evenly distributed flow till the Jan'21 deadline, we estimate the potential average daily trading volume (ADTV) level impact is marginal at 1%/3% of current 3 million ADTV for mid/small caps respectively," it said in a note on 14 September.

Edelweiss Securities Ltd thinks that given the radical rejig, potentially the entire small-cap universe may see a sharp rally. “Since 2010, every single year, about 45-50% of the top quartile performing small- and mid-caps have been category leaders. And, the average market returns of leaders outscore others by a huge margin. We believe this will be a fundamental trait that investors will look at as they churn/shift flows," it said.

Others concur. “A full re-balancing for the entire multi-cap assets under management (AUMs) would have driven potential flows of $ 1.7 billion and $3.8 billion into mid and small-caps (MFs likely to initially add to existing holdings) - this would have had far-reaching ramifications on stock prices, given how thinly traded some of these stocks are. Non-MF investors may, in fact, have started to accumulate these stocks in the hope of a price-rally even before MFs take their decisions on how to deal with the new rules," said analysts at JM Financial Institutional Securities Ltd.

However, the brokerage firm added the need to incrementally buy mid and small caps may be lowered significantly after Sebi subsequently clarified that apart from re-balancing portfolios, MFs could alternatively facilitate switch to other schemes by unit-holders, merge multi-cap scheme with large-cap scheme or convert it to another scheme category.

As mid- and small-cap stocks are quite thinly traded, and inflows into them may require several weeks of trading to achieve the required re-balancing, it may take two-three months of continuous buying for multi-cap schemes to achieve the required re-balancing.

“In reality, MFs are not likely to buy all the 250 small-cap stocks but instead, the incremental investments would be in a sub-set that they consider worth investing based on the philosophies of the respective fund houses. Another likely issue is that even before the MFs get around to buying these stocks (if MFs are eventually required to do so), there could be a lot of non-institutional actions in some of the stocks in the hope of their prices rallying in due course of time due to the institutional buying actions that the circular could entail," said JM Financials.

Analysts Vinod Karki and Siddharth Gupta, ICICI Securities feel that risk tolerance of multi-cap fund investors will be tested as portfolio risk rises and could impact flows post the new Sebi guidelines. “Size as a proxy for risk is validated with deteriorating return on equity (ROE) as we move from large-caps to micro-caps and relatively weaker business models (although with exceptions) thereby resulting in rational investors assigning adequate risk spread over large caps," they said.

Mid- and small-cap stocks peaked out in January 2018 and since then they have had a bear run which has increased the earnings yield spread of micro, small and midcaps over large caps to 460 basis points (bps), 180bps and 110bps currently.

To be sure, from March lows, BSE Smallcap rallied 64.08% and BSE Midcap jumped 51% outpacing Sensex which has gained nearly 50% in the period. In 2017, both BSE SmallCap and BSE Midcap indices rallied 60% and 48.13% respectively leading to losses in following years as stocks with no fundamental support lost steam while valuations peaked. At current levels, BSE Midcap is available at 12-month forward price-earnings (PE) ratio of 21.75 times, BSE SmallCap at 18.69 while Sensex is at 21.29 times.

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