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Smaller stocks have recovered faster than blue chips as equity markets are gaining ground post the rout in March and as retail investors and high net-worth individuals (HNIs) invest in smaller stocks hoping to make quick money amid the market rally.

The BSE Smallcap index has gained more than 9% year-to-date and turned positive this year, outpacing the large stocks. The benchmark BSE Sensex is still down 5.28% since the beginning of the year, while BSE Midcap index has gained 1.24% during this period. On Wednesday, both the BSE Midcap and BSE Smallcap indices rallied for the eight consecutive session, the longest positive streak since January.

Both the indices have outpaced the Sensex, which has gained 50.39% from the lows hit on 24 March when markets crashed over 10% in one day. Since then, the BSE Smallcap index has surged 68.76%, while the BSE Midcap soared 56.03%.

The Nifty breaking above the 200 weekly moving average (WMA) in the middle of July signalled a structural bull phase for the market, which started the rally in mid and smallcaps, said Rusmik Oza, executive vice president and head of fundamental research, Kotak Securities. “In this calendar year, the BSE Smallcap Index had earlier peaked at the 15,000 level in end-January (just before the Union Budget) and after falling to below 9,000 in March, it has again come to 15,000 mark. The outperformance needs to be viewed against the backdrop of the huge underperformance of the Smallcap index versus the benchmark between 2018 and end of 2019," he said.

The active participation of retail and HNI investors is leading to a sharp rally in mid and small caps, Oza said.

A surge of new retail investors in equities saw an inflow of liquidity into smaller stocks as they offer lower entry points. Typically, in a rising market, smallcaps tend to grow faster than largecaps, which are generally preferred by institutional investors. However, despite the rapid rise, the valuation of the BSE Smallcap Index is still at a 10.37% discount to the Sensex. The valuation gap had touched a 5-year low at 24.38% in May.

At current levels, the one-year forward price to earnings (PE) ratio of BSE Smallcap is at 19.27 times, while the Sensex is at 21.05 times and BSE Midcap is at 22.45. Oza, however, cautioned that rich valuations of the benchmark indices is a key risk to mid and smallcaps.

“Any reversal in bond yields, or sharp rise in the dollar index could lead to sharp correction in global equity markets. Mid and smallcaps are prone to sharper corrections when there is fall in the benchmark indices. Keeping the unfavourable risk-reward ratio of benchmark indices in mind, one needs play the mid and smallcaps accordingly," Oza said.

After a massive rise of 59.64% and 48.13% of BSE Smallcap and BSE Midcap indices respectively in 2017, these smaller stocks have been under tremendous sell-off pressure. In 2018, BSE Smallcap was down 23.53% followed by a fall of 6.85% the next year. Similarly, BSE Midcap was down 13.38% and 3.05% in 2018 and 2019 respectively.

However, analysts at Morgan Stanley are confident that small and midcap stocks are ready for outperformance on the back of a growth recovery and attractive valuations.

“With monetary aggregates normalizing and significant policy action underway with a corporate tax cut last September, we think growth is set to turn. Smaller firms are likely to benefit more because of their operating and financial leverage. Small and midcap valuations are looking attractive relative to gross domestic product and money supply, setting the stage for outperformance versus largecap stocks in the coming months," said Ridham Desai (equity strategist) and Sheela Rathi (equity analyst), Morgan Stanley, in a note on 18 August.

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