Mid-, small-cap stocks take a breather—is this the perfect time to buy?

The Indian stock market hit new highs on Friday, driven by the US Federal Reserve’s decision to cut interest rates. This fuelled optimism in the market, with both the frontline indices Nifty 50 and Sensex recording healthy gains. While the market basks in the glow of record highs, undercurrents of unease ripple through the broader landscape, especially among mid- and small-cap stocks. There is a notable divergence in market performance. In the last one month, the Sensex rose 4.6%, the index of top 500 firms gained 3.8%, while the mid- and small-cap index increased 2.2%, and 4.1%, respectively. However, over the past six months, the mid-cap segment and small-cap segment had outperformed the blue-chip indices.

The disparity grew stronger as only 24% of the top 500 stocks have fallen 20% or more compared to their one-year highs but in the small-cap counters 37% stocks are trading at significant discounts to their 52-week peak while in the mid-cap space this share was just 20%. Moreover, half of all BSE-listed stocks have dropped 20% or more from their yearly highs, showed a Mint analysis. 

“Historically, large-caps take the lead, followed by mid-caps and small-caps. However, when the economy grows rapidly, small-caps tend to outperform with better earnings growth. With interest rates expected to decrease, this should benefit small- and mid-caps' earnings growth going forward, assuming the economy maintains its 7%+ growth rate,” Andrew Holland, CEO, Avendus Capital Alternate Strategies. This suggests that while mid- and small-cap stocks may face near-term volatility, they may offer substantial long-term growth potential for investors.

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Challenges loom

Several mid-cap companies, including Zee Entertainment, Vodafone Idea, and Rajesh Exports, have seen sharp declines, plummeting over 45% from 52-week highs. UCO Bank and Indian Overseas Bank also suffered, trading at discounts of over 30%, while well-known names like Bharat Heavy Electricals Limited (Bhel) and Indian Railway Catering and Tourism Corp. (IRCTC) experienced declines of over 20%.

The carnage in the small-cap space is evident with companies such as Sanmit Infra, JP Associates, and MK Proteins trading 70% below their 52-week price. Lancer Container and EKI Energy Services dropped over 55%, while Cochin Shipyard, MTAR Technologies, and Bharat Dynamics fell by over 35%. Though the challenges faced by each company varied, the spectre of financial ruin looms large over both Vodafone and JP Associates, as they struggle to navigate a treacherous landscape of debt and legal obstacles.

Mint's further analysis underscores the overvaluation of mid- and small-cap stocks, with a significant portion trading at substantial premiums to their historical (P/E) ratios. Around 39.4% of mid-cap stocks and 56.4% of small-cap stocks are priced at more than 50% above their 5-year median P/E. However, a correction seems to have occurred in the past year with only 6.7% of mid-caps and 18% of small-caps maintaining such high premiums, relative to their one-year median.

“Valuations have long been a concern in the broader market, yet these stocks continued to rally despite being considered expensive,” said Santosh Meena, head of research, Swastika Investmart. “However, there always comes a point when market euphoria fades. Domestic institutions, too, have shown signs of caution, holding significant cash reserves at elevated levels,” highlighted Santosh Meena.

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Recently, mid- and small-caps have been overbought, noted Holland. “Initially, new money is flowing into large-caps, but it will eventually rotate back to mid-caps and small-caps. It's more of a market rotation than anything.”

Fund managers in the mid- and small-cap funds are holding on to cash for some time, according to data collated from Fisdom research. In mid-cap funds, cash levels as a share of their asset under management has inched slightly from 4.7% to 5.2% between July and August while for small-cap funds it has largely stayed around 6.4% in the past five months. Notably, small-cap funds have maintained higher cash levels compared to mid-cap funds over the last 12 months.

Nirav Karkera, head of Fisdom Research, pointed out that fund managers are treading cautiously in the small-cap category, though cash levels don't reflect significant under-deployment. "While fund managers are indeed cautious with deployment in the small-cap category, the cash levels are in the comfortable range without any indication of significant under-deployment. A look at allocation toward non-small-cap stocks shows that managers are effectively using the 20% buffer to allocate to more liquid and comfortable large-cap bets," Karkera said.