Midcap, smallcap could continue to underperform in short term; here’s why

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As anticipated, the correction in midcaps has finally begun, albeit belatedly. On MoM basis the mid and small cap index had corrected by -6% and -11%, respectively. Lately on a relief bounce rally limiting the fall to -3.4% and -7% respectively, dated 15th March. The sell-off is deep on a stock-to-stock basis, especially for small and micro stocks. The primary concern revolves around inflated valuations, with no other discernible fundamental issues contributing to the downturn. This correction has triggered a broader market consolidation phase, with midcaps notably lagging, reflecting a pervasive sentiment shift.

The crux of a stock market rally hinges on two fundamental factors: earnings growth and influx of capital. While varied qualitative and quantitative considerations certainly contribute to the emergence of stocks and industries rally, but at the forefront lie these twin pillars of fundamental strength and liquidity.

When examining corporate earnings growth, it’s apparent that the performance in the December quarter slightly exceeded expectations, with a positive outlook for the continued robust growth in FY25. However, in retrospect, this growth trajectory is expected to taper off compared to the surge driven by pent-up demand from FY21 to FY24. For Instance, the Midcap150 index’s EPS (Earnings Per Share) CAGR was 35%. The YoY EPS growth in FY24 is estimated at 30% YoY and forecast to slow to 20% in FY25.

At the same time, the price growth of the midcap index is 60% in FY24, which traces earnings growth by 2x times, leading to premium valuation. In February 2024, the premiumization of midcaps over large caps reached a record level of 40%. Currently it is consolidated at 23% above the long-term average of 17%. This narrowing is deemed appropriate as future earnings growth is expected to ease in FY25. The key factors for moderation in profitability is temperament of pend-up demand, an increase in input costs, and slowdown in the rural market.

When considering the role of capital inflow, a significant driver for midcaps in FY24 was the substantial influx from retail investors. Retail investors are pivotal players in the Indian stock market, demonstrating considerable buying activity since April 2023 across both direct investments and mutual funds. NSE data shows that in the last five years between 2019 and 2023, over new 12cr investors were registered. In January 2024 alone, more than 54lac of investors were added. As per BSE, as of February 2024, the number of registered investors stood at nearly 16.1 cr. Retails’ exhibit a strong presence in mid and small caps as well as in the futures and options segment.

If we look at March equity net inflow data, FIIs and DIIs were strong net buyers. MF have brought better MoM Rs 17,141cr and FIIs Rs 38,653cr till 13th of March. So, non-other than retail investors are the culprits for the Midcaps fallout in March 2024.

SEBI’s declaration that Mid & Small caps are at irrational exuberance and asking MFs to perform a stretch test of the scheme has impacted the sentiment of retail & brokerages. Many MFs have stopped new lumpsum & SIP in Mid & Smallcaps while ongoing SIPs are continued. Brokers have asked clients to partially liquidate their leveraged positions as volatility increased during the month, triggering a sell-off this week.

Midcaps are currently experiencing a transient period of flux, driven by excessive enthusiasm that has propelled prices well beyond earnings growth. We presume that the valuation will consolidate in the medium-term. However, assume that midcaps will be able to hold the long-term premium to large caps. The long-term average premium is 17%, hence, on an average term, the medium-term downside should be protected by not more than further -6% price erosion. We envision this consolidation to be achieved through a blend of time and price corrections.

We don’t expect a further deep price cut, as corporate earnings are forecast to be healthy at 20% in FY25. Moreover, the upgrade of India’s GDP growth to 7%, based on better-than-expected quarterly GDP growth announcements in FY24, hints at the prospect of business growth accelerating later in the year as both the economy and stock market find stability.

We anticipate a resurgence in retail inflows during Q1FY25 based on tax planning, portfolio restructuring, Lok Sabha election and final budget. However, we expect moderation in valuation from prolonged high twenties to high teens due to combination effect of a slower global economy and moderation in profitability. The current one year forward P/E of Midcaps is above the long-term average at 25x, and main index is at 20x. We do expect a positive and balanced-out return from midcaps in FY25 compared to the bumper performance of FY21 to FY24. Stock pick will the key determining factor.

First published in Mint

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