Don't be bothered by different reports on midcap and smallcap stocks

In the past six months, while the Sensex and Nifty have provided returns of around 15-16.5%, during the same period, the BSE Midcap Index has increased about 35%, and the BSE Smallcap Index has registered an increase of approximately 38%. After significant gains in small and mid-cap indices, there is a debate about whether this trend is sustainable. In other words, will the rally in small and mid-cap shares continue? Kotak Institutional Equities and Nuvama have different perspectives on small and mid-cap shares. First, let’s understand the arguments presented in the reports by Kotak Institutional Equities and Nuvama. Then, we’ll discuss what to do with small and mid-cap shares.

Kotak Institutional Equities believes that the recent surge in small and mid-cap shares is primarily driven by investor enthusiasm or irrational exuberance. Expectations for future returns on these shares have also increased significantly, despite no changes in the fundamentals of these companies. While fundamentals in most sectors have not seen significant changes, the participation of inflows and new retail investors in mid-cap and small-cap funds has boosted market sentiment.

According to Kotak, most of the sector-favoured shares associated with institutional investor consumption have underperformed, meaning they have provided lower returns. Demand related to consumption has been weak. Additionally, the valuations of these shares are either high or have reached historic highs.

In fact, after better-than-expected results in the first quarter of FY24, both foreign and domestic institutional investors began buying these shares aggressively. The appeal of these shares also increased due to the strong outlook for the Indian economy because during periods of economic growth, small and mid-cap shares tend to perform better, which is attractive to investors seeking higher returns.

Kotak Institutional Equities experts believe that most of these shares are currently priced with a significant positive discount, meaning that their prices have already been influenced. Therefore, they don’t see sustained bullishness in these shares at their current levels. While some of these shares have had an impressive historical performance, their future outlook may not be as favorable. Some shares appear to have a promising future, but their historical track record is less impressive, and some shares neither have a strong historical performance nor a promising future.

Retail and institutional investors’ new favorites among small and mid-cap shares include companies in the capital goods, defense, electronics manufacturing services (EMS), railways, real estate, and renewables sectors. However, Kotak believes that in the last 3-6 months, these shares have delivered strong returns due to the broader investment narrative. Kotak expects the investment cycle in these sectors to remain positive, but it’s worth noting that most of these sectors fall under the business-to-government (B2G) or business-to-business (B2B) category. Due to weak execution and governance track records, there isn’t a high level of confidence in the quality of these shares. Therefore, revenue and profit expectations for companies in these sectors may be overly ambitious.

On the other hand, Nuvama, the other broking house, believes that there is currently no bubble-like situation in at least small and mid-cap shares. However, investors should remain cautious as there isn’t an expectation of significant outperformance. There are two reasons for this. First, many of the discounted small and mid-cap shares that were downgraded from the fourth quarter of FY23 have already seen a rally since June. Second, these shares have seen an increase in valuation premiums compared to giants, and their 1-year forward price-to-earnings multiple is higher compared to the 10-year average PE. The PE multiple indicates how many times a company’s share or an index is trading in the market relative to its earnings per share (EPS).

According to Nuvama, companies such as Crompton Consumer, Blue Dart, PI Industries, Mahanagar Gas, UPL, Sterling & Wilson, Teamlease Services, and Prince Pipes have not participated in this year’s rally so far, but they have triggers to perform in the next 2-3 quarters.

Moreover, Nuvama has also prepared a list of shares that have been performing well, but their earnings growth and certainty are both significantly high. This list includes names like Polycab, KEI Industries, APL Apollo Tubes, Escorts Kubota, Coforge, and Syrma SGS.

Nuvama’s top mid-cap and small-cap picks include Polycab, Blue Dart, Coforge, Escorts Kubota, Prince Pipes, PI Industries, BHEL, APL Apollo Tubes, and Sterling & Wilson.

So, in conclusion, it can be said that not all mid-cap and small-cap shares are in a bubble-like situation. Only those shares that have seen significant surges should be approached with caution, as investors like Pratap may need to be a bit more vigilant. However, before choosing mid-cap shares, it is advisable to pay attention to the criteria suggested by experts.