Does the recent sell-off indicate a reversal in the small-cap tide?

Correctionin smallcaps will bring bloated valuations to normal levels as they had run up beyond their fundamentals

The sell-off seen in small-caps on December 20 was led by profit-taking after a steady rise in the preceding sessions and rising concerns about a potential bubble in the segment, experts said. Smallcap stocks sharp correction on December 20, after rallying over 40 percent so far in 2023.

The BSE Smallcap index tumbled nearly 3.5 percent while the Nifty Smallcap 100 index fell around 5 percent from the day’s high to a low of 14,951. According to VK Vijayakumar, Chief Investment Strategist at Geojit Financial Services, the profit-booking is 'very normal'. "Correction was long overdue and will make markets healthy," he said.

According to Elara Capital, Mid & small-caps’ catch-up with the long-term outperformance rate over large caps is broadly done. "Valuation premium has closed gap with previous peaks. Hence, the room for further catchup outperformance is limited, in our view. Further, unlike in September, we see fewer stocks where valuation is still inexpensive," the brokerage said.

However, analysts at Elara see the last leg in the mid & smallcap rally still left, driven by deployment of high cash levels and large-cap holdings in the smallcap mutual fund schemes. "Continued strong domestic flows would support this rally," they said.

The calendar year of 2023 has seen small-cap and mid-cap rallies with a lot of stocks turning multibaggers. The Nifty Smallcap index has gained around 47 percent in the last on year. Within the small-cap realm, relatively smaller market capitalisation companies have experienced higher average returns, along with a greater proportion of companies providing returns exceeding 100 percent.

Valuation-wise, smallcap pockets were trading at 26 times (x) price-to-earnings (PE) ratio based on FY24 earnings as against 21x PE ratio of benchmark Nifty. This correction will bring bloated valuations to normal levels as they had run up beyond their fundamentals, Vijayakumar said.

The market capitalization to GDP ratio of mid-cap and small-cap stocks is approaching 25 percent and 20 percent, respectively, aligning closely with the levels observed in 2007. The fundamentals in both segments remain strong.

Looking ahead from 2023 to 2025, robust earnings growth is expected, with the mid-cap and small-cap sector anticipating growth rates of around 25 percent and 30 percent, respectively. This substantial earning growth provides a rationale for the current valuations in these categories.

The valuation of mid and small-cap stocks is not comforting, and there is evident froth in many of these sectors, according to Aishvarya Dadheech, Founder & CIO of Fident Asset Management. As we approach the next quarter in a couple of weeks, Dadheech emphasizes the importance of fundamental support through improved reserves to rationalize the current valuations.

"I firmly believe that the decline on December 20 is more of a healthy consolidation. Investors need not be overly concerned, but caution should be exercised moving forward," he said.

Jigar Mistry, co-founder of Buoyant Capital stated that the valuations of many small-cap businesses have started embedding significant potential upsides. "Unless profits continue to surpass expectations, the odds of the small-cap rally not concluding favourably are rising," he said.

The pressure could be higher in the smallcap space now, so participants should reduce their positions and maintain strict stop losses in remaining trades, recommends Ajit Mishra, SVP - Technical Research at Religare Broking Ltd.

Analysts at Kotak Securities believe that several low-quality midcaps and smallcaps, in general, are in a bubble market, with the market attaching unrealistic narratives to many stocks. The brokerage sees better reward-risk in large-cap stocks, given balance given more reasonable valuations versus lofty valuations of most mid-cap and small-cap stocks.

However, Unmesh Sharma, Head of Institutional Equities at HDFC Securities believes that one can't say that the rally in small-caps is over. "There's a lot of domestic liquidity, which cannot leave the country. This liquidity tends to benefit mid and small-caps," he said.

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More money is chasing fewer stocks and that is resulting in higher stock prices across the board, whether blue-chips, midcaps, or small caps, according to Devarsh Vakil. Deputy Head - Retail Research at HDFC Securities. "Many investors are sitting on the sideline and waiting for the markets to correct and this means that even if prices do come down they will find buyers at the lower levels," he said.