Bubble alert: India’s small-cap stock rush needs risk reduction

The Securities and Exchange Board of India’s raised concerns over retail investors getting over-exposed to high-risk small- and mid-cap stocks.
The Securities and Exchange Board of India’s raised concerns over retail investors getting over-exposed to high-risk small- and mid-cap stocks.

Summary

  • Sebi recently asked India’s mutual fund industry to take precautions. Investment caps for high-risk stocks may help but we also need far greater public awareness of asset inflation.

The Association of Mutual Funds in India has requested MF houses to take pre-emptive steps to safeguard investors. It took its cue from concerns raised by the Securities and Exchange Board of India’s (Sebi) over retail investors getting over-exposed to high-risk small- and mid-cap stocks. The market regulator’s worry is understandable. Household investors have been falling head-over-heels in love with shares in these categories, attracted by sizzling price upshoots, even as more and more money coming in fuels a self-fulfilling rally in equities that has taken them past levels their earnings can justify. Over the last year or so, the benchmark small-cap index has climbed more than 70%, while the mid-cap index has risen by over 60%. In comparison, large-cap indices show gains of under 30%. As estimated, flows into focused mid- and small-cap MFs in 2023-24 as a share of net inflows into equity funds have jumped to 42% from 29% in 2022-23 and 16% the year before. Which way retail investors are swinging is clear. Given the spike observed in mutual-fund folios, however, many of these investors are probably new to equity markets. This means they may have no experience of the turbulence these segments may undergo if and when the tide turns.

With plenty of money chasing rather few stocks, prices have skyrocketed, but the pace of these companies’ earnings growth has not been able to keep up. This has led to asset inflation, as visible in enlarged valuations. The Nifty Smallcap 250 index, for instance, is currently trading at a trailing price-earnings (PE) ratio of over 28, much above the 20-odd level that’s considered reasonable for this category. While prospects of rapid profit enlargement could sustain such PE ratios, evidence of this is outweighed by that of outsized inflows. Even a new wave of startups going public may not suffice to satisfy swelling demand without amplifying risks. Small-cap businesses generally have smaller equity bases, often with only thin slices of their equity pie available for open market trading. With less trading activity in these stocks, they are also harder to liquidate. These factors combine to spell extra price volatility, as relatively small ‘buy’ or ‘sell’ orders can cause sharp movements. So, while quick upside gains give these assets their allure during bull runs, by the same token, they are prone to sudden drops as well. And sell-offs in these frothy segments could send investors reeling.

At one level, it is the MF industry’s responsibility to invest safely. Having done a good job of marketing MFs as a well-regulated investment option for households, it needs to live up to its promise. Since a market turn could result in an upswell of redemption demand that’s not easy to meet, some funds have reportedly carried out stress tests by simulating adverse conditions. This is reassuring. Others have stopped lump-sum investments. In addition, some small-cap MFs have capped the money taken from investors. Cautious deployment of investor cash and a moderation of inflows should help lower risks. Even so, at another level, it is no less important to acquaint investors at large with the problem. High capital appreciation over the past year or so may have given rise to unrealistic expectations. These need to be tempered. What we get as returns from stock investments, after all, is ultimately a function of the profits these companies make. This link, however, appears to have snapped. For the sake of capital-market stability, it needs to be restored.

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