Mid-caps, small-caps soar despite no material change in fundamentals; irrational exuberance could be at play, says Kotak

Mid and smallcap indices have been on a record-setting spree for the last several sessions. The BSE Midcap index has jumped nearly 31 per cent this year so far while the BSE Smallcap index has jumped 33 per cent this year. Benchmark Sensex has jumped 10 per cent this year so far.

“We see a limited point in trying to find fundamental reasons behind the steep increase in stock prices of several mid-cap and small-cap stocks. There is no meaningful change in the fundamentals of most companies; in fact, they have worsened in many cases. The primary driver of the rally appears to be irrational exuberance among investors, with high return expectations (and purchase decisions) being driven by the high returns of the past few months,” said Kotak Institutional Equities.

Some of the mid-cap stocks, such as IRFC and REC have surged 175 per cent and 117 per cent, respectively, in the last six months. While in the small-cap space, shares of Mazagon Dock (up 198 per cent), BSE (up 184 per cent), Suzlon Energy (up 180 per cent), Rail Vikas (up 154 per cent), Cochin Shipyard (up 151 per cent) and Kalyan Jewellers (up 110) have surged over 100 per cent in the last six months, Kotak pointed out.

Kotak underscored that the fundamentals of most sectors have not changed much. However, market sentiment is quite exuberant, based on (1) a steep increase in the prices of many mid-cap and small-cap stocks, (2) large inflows into mid-cap and small-cap mutual funds, and (3) a huge number of new retail participants in the mid-cap and small-cap funds.

“The strong performance of the mid-cap and small-cap indices has possibly pushed up return expectations among retail investors,” Kotak said.

Kotak pointed out that most of the traditional favourite mid-cap stocks of institutional investors in the broader consumption sector have been large laggards in the ongoing mid-cap rally, given weak consumption demand in general. However, the valuations of these companies have stayed high or gone to historically high levels due to earnings cuts.

“We see risks of (1) lower profitability and (2) lower valuation multiples due to weakening business models (erosion of business moats of brand, distribution market structure and product),” said the brokerage firm.

Kotak observed many of the new favourite mid-and-small-cap stocks of institutional and retail investors are in the broader ‘investment’ sector (capital goods, defence, EMS, railways, real estate, renewables). These stocks have delivered eye-popping returns in the past 3-6 months, led by the broader ‘investment’ narrative.

“We expect a decent investment cycle, but we are not sure about the quality of many of the stocks given their historically weak execution and governance track records. In addition, many of these sectors fall in the B2G (business-to-government) or B2B categories, which raises issues around execution and profitability. We believe that market expectations for both revenues and profitability may be too optimistic across these sectors,” Kotak said.

“The last lot of the new favourite mid-and-small-cap stocks fall in the dubious category of ‘turnaround’ stories. Many of these companies have been through serious operational and financial challenges (including bankruptcy) in the recent past, but the market has high hopes of these companies doing well in the future. We are not sure of the basis of the market’s confidence,” said Kotak.

The brokerage firm has dropped its recommended mid-cap portfolio as it said it cannot find too many stocks beyond the BFSI space that offer a decent potential upside to its 12-month fair value.

Read more: Are small-cap stocks in a bubble? Experts tell you how to trade in smaller companies

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Disclaimer: The views and recommendations above are those of individual analysts and broking companies, not of Mint. We advise investors to check with certified experts before making any investment decisions.

Updated: 11 Sep 2023, 05:49 PM IST