Low free float behind rally in most midcap, smallcap stocks: Kotak study

Since April, BSE midcap and smallcap indices have surged by around 35% and 40% respectively

An analysis by Kotak Institutional Equities shows that the recent rally in midcaps and smallcaps is led by top-performing stocks with lower free float than underperforming ones. Better fundamentals aided the outperformance in some cases and compelling narratives in many others, it says.

Stocks in the top and bottom performance quartiles had different free floats. Notably, delivery value, relative to free float, was much higher for the top performers. Kotak's analysis reveals that many top performers have seen a significant surge in delivery volumes. This increase is attributed to rising expectations of strong returns from midcaps and smallcaps. The influx of funds into midcap and smallcap mutual funds reflects investors' anticipation of high returns and has contributed to the sustained rise in delivery volumes.

Delivery value dropped sharply in October from a month before, while largecap stocks maintained stable delivery volumes, the report says.

In 2017, the Indian midcap rally witnessed stocks with lower free float delivering remarkable returns. This is similar to the current trend, but it's important to note that the 2018 decline in the Nifty Midcap-100 index had a significant impact on top performers. Kotak draws parallels between the two situations but refrains from making conclusions about the current midcap and smallcap rally.

Kotak thinks that the market's high expectations for midcap and smallcap stocks may be overtly optimistic. Stock returns have outpaced fundamental improvements. The recent price correction in some of these stocks reflects market nervousness about holding them after such significant gains. To maintain their strong stock performance, the top-performing companies might need to demonstrate more significant improvements in their financial and operational performance, the report said.

Since April, the BSE MidCap and SmallCap indices have surged by around 35 percent and 40 percent. Analysts have cautioned that this rapid rise lacks strong fundamental reasons, and investors should be careful due to elevated valuations.