There is one segment in the investing world where greed and fear are both ruling at the same time – Indian Small and Midcap (SMID) stocks.
The monster rally in SMID indices has led to their outperformance in relation to the most watched benchmark indices – the Nifty and the BSE Sensex. The consequences are manifest in valuations that are considered stretched, if one is charitable, and downright unrealistic, if one is even remotely practical.
MSCI India Small Cap index, which was historically trading at a discount to both the US and China, is now at a premium. The one year forward price to earnings is at a more than 30 percent premium to the US and 129 percent to China, data from DSP Mutual Fund shows.
Although these numbers have induced fears of overheating with the likes of Kotak Institutional Equities stopping recommendations on mid and small cap stocks last September, funds are flowing to these stocks and the mutual fund schemes that own them.
For some, it may be the greed to get rich quick, but for others it’s owning a piece of a business that could get bigger with earnings growth – the fundamental reason behind most equity investment. The December quarter earnings show SMIDs grew more than the big companies.
“The Nifty PAT growth of 16% on year was significantly below that of the BSE 500 at 26%, reinforcing our thesis of democratization of profits and reinforcing our positive view on SMIDs,’’ said Seshadri Sen, strategist at Emkay Research, a brokerage firm.
Historically, investors have been biased toward large cap stocks because of the cushion they provided during the downturn and the difficulties associated with piercing the veil of governance in smaller companies.
That also led to the SMIDs trading at a discount to their bigger competitors. But that aversion gives way to optimism as overall rally leads to large caps getting fully priced early and late comers pick the untouchables.
The distinction between SMID and large is more an institutional invention to save themselves from getting trapped during market crashes when investors rush to the exit door. Because of sheer lack of liquidity, it becomes impossible to sell SMIDs to repay investors. But every mutual fund company runs a mid and small cap fund though.
In the last 12 months, these asset management companies have benefited from it. Small cap funds have seen an inflow of Rs. 42,037 crores, the highest among all equity categories, followed by mid cap funds at Rs. 23,346 crores, data from Franklin Templeton Mutual Fund shows.
When it comes to value investing, whether it is a midcap or a large cap does not make much difference for long term investors. To be sure, it is the SMIDs that transform into large caps with higher earnings growth due to smaller bases and better returns. Infosys Technologies and Asian Paints were mid caps at some point in time. One 97 Communications, the owner of Paytm brand, was a large cap with a market value of nearly $19 billion when it listed, and is probably on its way to become a small cap with its value falling to less than $3 billion.
Every bull run has to end, and so will this. When that happens the fall in the price of SMIDs would inevitably be sharper than in the large cap stocks. It would not be because companies’ business have become unviable, but the liquidity in those stocks may have dried up.
Even companies with strong earnings growth and robust balance sheets would tumble when the tide turns. Of course, there would be bad apples leaving investors high and dry. But that won’t be restricted to SMIDs, but large ones as well. Investors who have seen cycles would remember Reliance Power and Jaiprakash Associates or Punj Lloyd. It is not just the size that matters for investing, but the sustainability of the business and the soundness of its financials.
