Investor Interest In Small And Mid Cap Stocks Is Inevitable, SEBI Nudge Notwithstanding

It has been over a month since the mutual fund body Association of Mutual Funds of India (AMFI) wrote to Asset Management Companies flagging the issue of 'froth' building up in the SMIDs segment of the markets. The industry body asked fund houses to moderate flows into SMID mutual fund schemes and rebalance portfolios in favour of large-cap companies. Even stress tests were suggested aimed at assessing the risk associated with any redemption pressure.

This was followed by some Open ‘Mouth’ Operations – now an accepted practice followed by global regulators to nudge markets. Madhabi Puri Buch, chairperson of Securities Exchange Board of India (SEBI) -- the market regulator, did just that  at an industry event on March 11.

Hinting at irrational exuberance in the SMID space, Buch said: “Some people call it a bubble; some may call it froth. It may not be appropriate to allow that bubble to keep building, because…by definition bubbles burst; and when they burst, they impact investors adversely, which is not a good thing.”  Even the Reserve Bank of India (RBI) raised similar concerns on ‘froth’ in SMIDs.

So, have markets taken the cue provided by the regulators? To deter investors from the SMID space, many fund houses stopped lumpsum investments in small and mid-cap funds. Even some systematic investment plans (SIPs) in these funds were halted. Most importantly, fund managers started rebalancing their portfolios in favour of large-cap companies. No wonder the benchmark 30-share Sensex and 50-share Nifty are clocking new highs!

However, despite all the nudging by the regulators, and to the surprise of many, the correction in the SMIDs as a pack, through March, has been shallower. While the 50-share Nifty recorded a gain of 1.6 per cent in March, the 100-share NSE mid-cap index fell by only 0.5 per cent and the 100-share NSE small-cap index fell by 4.4 per cent.

For all of FY2023-24, while the 50-share Nifty 50 rose 28.6 per cent, the mid and small-cap indices jumped 60.1 per cent and 69.8 per cent respectively. The outperformance of the broader market was around 30 per cent and 40 per cent last year. It was way above the 5-year average of 6 per cent and 10 per cent and the 10-year average of 6 per cent and 7 per cent.

Nonetheless, the series of events in the SMIDs space raise a few questions:

• Have the regulators acted prudently by meddling with market sentiments?
• If so, then was the timing of flagging the issue right?
• Will the SMIDs segment see more correction?
• Can investors ignore SMIDs just because the regulators think that the ‘froth’ in valuations is due to higher inflows into SMIDs and not the fundamentals?

Nudging At The Right Time

There was an exceptional run in mid and small-cap stocks last year. Domestic institutional investors have invested a cumulative US$80 billion since 2021. The mutual fund industry assets under management (AUM), which stood at Rs 40 trillion in April last year, breached the Rs 50 trillion mark in December 2023 and now stands at Rs 54.5 trillion.

Investor contribution to mutual funds is more towards equities as compared to debt products. Even within that, SMID cap schemes have appealed to the investors the most. Around Rs 70,000 crore have flown into these schemes in the last one year itself.  

Strong equity inflows into mutual funds have been supported by retail systematic investment plans (SIP) flows with 38.5 million gross new accounts between April 2023 and Feb 2024. The average monthly SIP contribution in FY2023-24 till February stood at around Rs 164 billion as against an average of 129 billion in FY2022-23. Most notably, the largest share of inflows over the last year went towards the mid- and small-cap schemes.

Most data points hint towards an irrational exuberance in the SMID space. By deterring investments in the broader markets, the regulators are ensuring that they don’t have to face any systemic challenge if the markets turn for the worst. SMID companies are infamous for their low liquidity and high impact costs, especially during the downturn.

It tests the fund manager’s ability to liquidate investments in case of heavy redemption pressure. Both the intention and timing of the regulators’ move seem right.

"Before markets could take it to levels, which would warrant a crash-rationalization, comes a nudge from the regulator in terms of caution for the SMID segment. The regulator played a proactive role, asking the asset management companies about stress testing for their exposure in the SMID segment,” Prashant Joshi, Senior Vice President, Motilal Oswal Asset Management Company said in a product note.

While as a pack, the SMIDs equity indices have not fallen much, some stocks have fallen by more than 30 per cent. With this, the valuations have normalised, making the broader market attractive. According to global brokerage firm JP Morgan, valuations for mid-caps have now pulled back from 38 per cent at end-Jan 2024 to 23 per cent now (the PE ratio was close to the 19 per cent average since 2019).

“In our view, the recent correction creates opportunities to accumulate quality stocks in the SMID space in India," JP Morgan said in a note on April 1.

Can investors ignore SMIDs?

Here are the top three reasons why in the near term SMIDs could stay volatile, but their surge is inevitable. Among other things, reasons like higher investors participation, high earnings potential and investor-required themes make a case for investment in SMIDs. 

SMIDs and India's growth go hand in hand: Today, the constitution of the large-cap index is tilted towards a few sectors like oil & gas, banking and Information Technology. So where do investors seek opportunities in other sectors?

"Beyond near-term volatility, we believe small and mid-caps (SMIDs) offer higher exposure to favourable themes such as manufacturing, infrastructure development, EV, digital transformation, green energy and sustainability; and have historically offered higher alpha opportunities. These higher returns are driven by superior earnings CAGRs for mid-caps/small caps,” the JP Morgan note said.

Another brokerage firm, Emkay, echoed similar sentiments in a March 25 note. “The incremental profit pool is shifting away from sectors like banks/FMCG/IT, which dominate the large-cap universe. Manufacturing sectors, on the other hand, are dominated by SMIDs, which, willy-nilly, have driven the market’s rally (last year)," it said.

"This trend should continue to be the focus of the government’s policy and incremental growth is unlikely to change soon. SMID rallies are inevitable, inherently more volatile, and offer frothy valuations, followed by short and sharp corrections, like this one (in March)," Emkay noted.

Strong fundamentals: Investors’ attention towards SMIDs is not in a vacuum. Most small companies have an earnings story to tell, which is getting captured in the market prices. Additionally, they offer a wide variety of themes to invest in.

"Domestic investor’s increased participation (in SMIDs) is not dreamy; it is backed by a strong show on fundamentals. Fiscal year 2021-2023, large caps have delivered earnings growth of around 21 per cent compared to 31 per cent for mid-caps and 48 per cent for small caps," said Joshi at Motilal Oswal.

“Going forward also, FY2024-25 is also reflecting continued strength in earnings growth for mid & small cap at 31 per cent and 33 per cent respectively vis 16 per cent for large caps," said Joshi Thus, higher expected growth supports a valuation premium.

Structural Reasons: The trend in new demat accounts and mutual fund folios, young demography and liking towards equity as an asset class and availability of distinctive investment themes all support the view that investments in the SMIDs space are unlikely to die down soon.

2024 is not 2018

Indian SMIDs were in a similar situation in 2018, the mid-cap and small-cap indices corrected by 24 per cent and 31 per cent respectively between January-October 2018. This kept the overall sentiment low in the stock markets. But 2024 is not 2018. However, the current macro and market dynamics are very different.

"Empirical evidence indicates that the trigger for bear markets within small-caps (say, more than 20 per cent fall) has historically emanated from being in a high valuation zone, followed by a slump in economic growth and/or ‘monetary tightening cycle,’ both of which appear unlikely currently given the recent India GDP upgrades and benign interest rate outlook," said ICICI Securities in a note. 

Despite recent volatility, and the hunt for the next 'Infosys', it seems that activities in SMIDs is unlikely to die down sooner.

(The author is a Mumbai-based analyst and researcher. Views expressed are personal)