Mid-, small-caps steal a march over Nifty

Mid- and small-cap shares have outperformed large-caps by a wide margin since July this year. The Nifty Midcap index has returned 17.1% while the Nifty Smallcap index is up 14.8% during this period, compared with returns of 11.9% for the Nifty 50.

Post the recent run up, the Nifty is now trading at 19.5x its one-year forward price to earnings multiples, above its 10-year average of 16.9. Mid-caps are trading at a premium of 10-15% to the Nifty while small-cap indices are trading at 15-16 P/E, slightly above the long-term average of 14.4x, according to experts.

The fall in the broader market was much more steep in the first half of the year compared to the Nifty, which made valuations really attractive in many of the counters and attracted investors, said Menon.

“Despite the impact of inflation, these companies have been able to manage their operating margins pretty well which gave confidence to investors. The festive season, too, began with a bang and led to a spurt in consumption demand, especially in the discretionary space. Niche sectors and themes such as travel and tourism, QSR, retail, building materials and defence have seen a lot of buying interest and are likely to stay in focus in coming months too,” said Menon.

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What has also helped is the orientation of mid- and small-cap segments towards sectors such as capital goods, chemicals, building materials and consumer discretionary, typically catering to the domestic market, which has been relatively more insulated than outward-facing sectors such as IT and pharma.

FPIs sold shares worth $28 billion in the six months to June, but turned net buyers in July and August. Since September, they have sold shares worth $1.5 billion. FPIs typically prefer transacting in large-cap companies rather than mid or small-cap ones. Domestic institutional investors such as mutual funds, on the other hand, have been net buyers for most of this year on the back of sustained inflows from retail investors that include systematic investment plans of Rs 12,000 crore every month.

Mid- and small-cap segments typically take a bigger knock than large-cap stocks when market conditions turn adverse. In 2018, mid- and small-cap shares tanked between 12% and 20% on an average, leading to panic among investors.

“The strong outperformance of the small cap index relative to Nifty post April 2020 has brought back attention to this segment. Thankfully, the excesses of CY17, when this segment outperformed Nifty and commended premium valuations to large caps, were not repeated in this cycle. Thus, while valuations are elevated and bubbles of exuberance are evident, the segment as an entirety has not reached the levels seen in December 2017,” said Anoop Bhaskar, head of equities at IDFC MF.

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That said, with markets likely to face several headwinds in the form of rate hikes by central banks globally, geopolitical tensions and economic slowdown, experts advise investors to limit their exposure to such stocks to 30-35% of their equity portfolio.

“Global growth slowdown as well as India-specific risks could act as catalysts for earnings cuts in our view. Given current valuations and potential risk of global events playing out unfavourably, we would seek comfort in large caps for now,” said Amish Shah, head of India Research, BofA Securities.