Is there a bubble in mid, small-cap space? Kotak and Nuvama slug it out
Mid and small-cap stocks have seen significant gains, prompting a debate about whether the trend is sustainable or not. Kotak Institutional Equities believes the rally is driven by irrational exuberance, while Nuvama Wealth Management sees no bubble in the mid-cap space.
PremiumThe sharp gains in mid and small-cap space have not only startled investors but also prompted a debate among experts regarding whether this upward trend will persist or if it is likely to lose momentum in the near future.
A week ago, brokerage firm Kotak Institutional Equities said "irrational exuberance" was driving mid-cap and small-cap stocks higher as there was "no meaningful change in the fundamentals of most companies".
"The primary driver of the rally appears to be irrational exuberance among investors, with high return expectations (and purchase decisions) being driven by the high returns of the past few months," Kotak said in a report on September 11.
On the other hand, brokerage firm Nuvama Wealth Management believes there is no bubble, at least in the mid-cap space.
A bubble or not a bubble?
This year so far has seen decent gains for the equity benchmarks the Sensex and the Nifty but the mid and smallcap indices have seen much bigger gains.
While the Sensex and Nifty have gained 12 per cent each this year so far (as of September 15 close), the BSE Midcap index has gained 28 per cent while the Smallcap index has risen 31 per cent.
Domestic as well as foreign portfolio investors (FPIs) started lapping up mid and small-cap stocks after their better-than-expected Q1 numbers. Moreover, the robust outlook of India's economy also attracted investors to these stocks as in a growing economy, mid and small-cap stocks tend to rise more, making them attractive to investors seeking higher returns.
Read more: Are small-cap stocks in a bubble? Experts tell you how to trade in smaller companies
Experts at Kotak Institutional Equities seem to believe most positives are already discounted and there is no significant change in fundamentals. So, the rally in mid and small-caps is unsustainable.
But experts at Nuvama Wealth Management underscore mid-caps warrant caution, but there is no bubble in this space.
What Kotak says about mid-caps, small-caps
Kotak sees varying degrees of exuberance in the mid-and-small-cap space, with some stocks with great history but potentially less favourable futures, some with great purported future but mediocre history and some mid and small-cap stocks with no history or possibly future.
Kotak said it does not see many fundamental reasons for the meteoric rise in the stock prices of many mid-cap and small-cap stocks in the past few months.
"The fundamentals of most sectors have not changed much. However, market sentiment is quite exuberant, based on (1) a steep increase in the prices of many mid-cap and small-cap stocks, (2) large inflows into mid-cap and small-cap mutual funds, and (3) huge number of new retail participants in the mid-cap and small-cap funds," said Kotak.
The brokerage firm added that the strong performance of the mid-cap and small-cap indices has possibly pushed up return expectations among retail investors.
Kotak pointed out that most institutional investors's traditionally favourite mid-cap stocks in the broader ‘consumption’ sector have been large laggards in the ongoing mid-cap rally due to weak consumption demand in general. On the other hand, the valuations of these companies have stayed high or gone to historically high levels due to earnings cuts, Kotak observed.
"We see risks of (1) lower profitability and (2) lower valuation multiples due to weakening business models (erosion of business moats of brand, distribution market structure and product)," said Kotak.
Many of the new favourite mid-and-small-cap stocks of institutional and retail investors are in the capital goods, defence, EMS (electronics manufacturing services), railways, real estate, and renewables sectors. Kotak pointed out that these stocks have delivered strong returns in the past three to six months, led by the broader investment narrative.
While the brokerage firm expects a decent investment cycle in these sectors, it is not sure about the quality of many of the stocks given their historically weak execution and governance track records. In addition, Kotak observed many of these sectors fall in the B2G (business-to-government) or B2B categories, which raises issues around execution and profitability.
"We believe that market expectations for both revenues and profitability may be too optimistic across these sectors," said Kotak.
The last lot of the new favourite mid-and-small-cap stocks, as per Kotak, fall in the dubious category of ‘turnaround’ stories.
"Many of these companies have been through serious operational and financial challenges (including bankruptcy) in the recent past, but the market has high hopes of these companies doing well in the future. We are not sure of the basis of the market’s confidence," said Kotak.
What Nuvama says about mid-caps, small-caps
Nuvama does not see a bubble in mid-caps even as it does not expect a great outperformance from them.
"On SMID (small- and mid-cap) outlook, our markers show mixed indications. Mid-caps warrant caution (valuations are above mean), but we do not see this as a bubble," said Nuvama in a report on September 15.
"We rely on multiple markers to ascertain whether SMIDs can outperform or underperform large-caps. Starting with trends in earnings upgrades/downgrades (pre- and post-quarter), we see that the share of stocks showing downgrades within SMIDs has fallen since Q4FY23, but the SMID rally since Jun-23 somewhat captures that," Nuvama said.
The brokerage firm underscored that SMID valuation premiums to large-caps have certainly expanded, but not to bubble-like levels. For instance, Midcap 100’s valuation premium average for 15 years is 16 per cent, but it has been 28 per cent for the past 10 years. The current premium is 36 per cent, Nuvama said.
Moreover, Nuvama highlighted that the Midcap index’s one-year forward P/E (price-to-earnings ratio) is 28 times while the past 10-year average is about 26 times.
"Our rolling return CAGR differential analysis also shows levels just above the mean. All told, we believe while a meaningful SMID outperformance is unlikely, we do not anticipate a huge under-performance, at least for mid-caps," said Nuvama.
Nuvama has compiled a list of stocks from its SMID coverage which have not participated in the rally year-to-date. These stocks, as per Nuvama, have triggers in store over the next two to three quarters.
Some stocks that make the cut are Crompton Consumer, Blue Dart, PI Industries, Mahanagar Gas, UPL, Sterling & Wilson, Teamlease Services and Prince Pipes.
The brokerage firm has also put out a list of stocks that have done well this year, but their earnings growth and certainty are both high. Some stocks that filter out here are Polycab, KEI Industries, APL Apollo Tubes, Escorts Kubota, Coforge and Syrma SGS.
Nuvama's overall top SMID picks include Polycab, Blue Dart, Coforge, Escorts Kubota, Prince Pipes, PI Industries, BHEL, APL Apollo Tubes and Sterling & Wilson.
There could be some justification for the optimism in the mid and small-cap space but the matter of concern is that many small and micro-caps of subpar quality are also soaring higher in the current bull run. This could lead to a crash in the segment.
"The real worry is that many small and micro caps of doubtful quality are also participating in the bull run, driven purely by emotion and momentum. In this segment, a crash is inevitable," said V K Vijayakumar, Chief Investment Strategist at Geojit Financial Services.
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Disclaimer: The views and recommendations above are those of individual analysts, experts and broking companies, not of Mint. We advise investors to check with certified experts before making any investment decisions.
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