The possibility of above normal gains in mid and small caps in the long-term…

As the risk averseness of the domestic market increased, mid and small caps started to under perform the broad market with huge losses. Key mid cap indices were down by about 10% in the last one month. Mid and small caps have been impacted due to selling by mutual funds and foreign institutional investors (FIIs) due to premium valuation compared to the large caps. Also, SEBI’s measure to have a stringent definition of mid and small caps led to  a reduction in the proposition of such stocks in mutual fund schemes, leading to selling. Due to the defensive nature of investors supported with stable outlook, a few sectors like IT, Consumer durables and Energy are doing well along with large caps. At the same time, world’s equity market was also volatile due to the trade-war and slowdown in world economy. And in this, India has started to underperform due to premium valuation in the emerging market, downgrade in earnings, muted Q3 results and risk of upcoming election.

The trend of these midcap stocks is expected to be muted in the near-term due to downgrade in earnings and reduction in liquidity from FIIs and mutual funds compared to the last quarter. Net inflow in equity by FIIs was negative in January at -Rs500cr while for mutual fund it was positive at +Rs7100cr but banks and insurance companies have sold shares of -Rs5000cr. We can expect a reversal in this trend as domestic market stabilizes by the general election with a stable outcome. India’s under-performance compared to EMs will also reduce given a positive development in trade deal between US and China, an additional trigger for the market.

We feel that the role of election in the muted performance of mid and small caps is very limited. Rather than generating short-term volatility due to risk of slowdown in economic activities and policy decisions, elections have never impacted the long-term trend of the market. This time, the pre-election volatility has been high due to unprecedented global factors and non-stop implementation of domestic reforms like demonetization, GST and IBC impacting the growth of domestic economy, given the short-term disruptive nature of big reforms. In spite of muted earnings growth, India’s valuation continues to be on the premium showing the interest of foreign and domestic investors as these reforms are expected to improve the growth of the economy in the long-term.

We feel that the valuation of such stocks are attractive. The current valuation is below the five year average creating an excellent opportunity to invest in mid and small caps through an SIP to capture above normal gains in the long-term. For example, the one year forward P/E of indices like Nifty-Midcap100 has reduced to 15x from a high of 25x while the low was 13x. The current dull momentum will reverse as the broad domestic economy is expected to improve in the next two to three quarters with stability in the global market.

Posted: 14 February, 2019