Midcaps may see some volatility in the coming days, says Prashant Khemka of Whiteoak Capital

Prashant Khemka, MD and founder of WhiteOak Capital Management

The last few trading sessions have been quite eventful for the markets. First, a dash to the all-time high, and then a sell-off in mid-caps. Where are the markets headed next? Moneycontrol’s N Mahalakshmi spoke to Prashant Khemka, MD and founder of WhiteOak Capital Management, an investment management company, to get some answers.

Edited excerpts from their interaction:

What is your reading of yesterday’s (September 12) sell-off in mid-caps?

If you look at the charts, small and mid-caps have been consistently increasing since March 28th. Almost ballistic, like the rocket taking the Chandrayaan to the moon. Now, this is the market. You can’t keep on going up like this. The reasons behind the success of various sectors and themes during this boom are often attributed to their fundamental strengths. However, the flow of funds into the small-cap and mid-cap segments also has a significant impact. I don’t have the numbers at the top of my head, but a disproportionately large amount of flows has gone into small and mid-caps.

Small and mid-caps, particularly small-caps, are less liquid segments of the market. They don’t have the capability to digest such large inflows in such a short period of time. There's just too much money chasing a fairly small, less liquid segment. Certain segments of the small and mid-cap market are popular among retail investors. These segments receive inflows from mutual funds, PMS and AIF segments, and also from individual retail investors and HNIs who invest directly in these popular themes. This has pushed prices over and beyond what fundamentals themselves might merit.

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The fund flow-driven push to stock prices will sooner or later have to unravel as that is not sustainable. Whenever markets go up like such, it's not necessary that one fine day they’ll revert and come down. It starts with some volatility. Yesterday (September 12) was the first day after five months that saw some volatility. You can expect more such instances in the coming days.

Do you see yesterday as a harbinger of bad times for small and mid-caps over the course of the year?

That would be too strong a statement. Firstly, to clarify, notwithstanding anything I'm saying, we are very bottom-up stock selection-based investors. We don't have any confidence in our own macro predictions, and certainly no confidence in anybody else's macro predictions or market predictions. So, let me give that important caveat.

I feel, that certain areas of the small-cap segment, such as the deep cyclical, domestic-oriented, manufacturing, power sector, and defence sector, are becoming overextended. At some point in the future—I don't know whether it's next month, next week, next year, or some point down the line—I believe collectively these segments of the market would be available at lower stock prices than they are today. Not necessarily the whole market.

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In large caps, there is no such frenzy. Large-caps are up mid to high single digits, year to date, which is like earning the cost of capital or time value of money. But these particular segments—deep cyclical, leveraged, somewhat weaker governance, highly domestically oriented—will be available at lower prices.

According to you, how stretched are valuations? Or If I were to put this question another way, how much of a correction is possible for this lot of stocks to come back to fair value?

I haven’t done proper calculations as such, but some of these stocks are up 100, 200, or 300 percent in the last four, five, or six months. So, some of these stocks can come down. If you’re up 100 percent and you’re down 50%, then you're flat. If you’re up 300 percent, and you're down 75 percent, then you're flat. So, some of these stocks can come down in a sustained downturn, 50 to 75 percent, and go back to where they started or even lower. Again, I'm not saying names. There would be certain names that would do very well from these levels as well, over time.

Also Read | BSE MidCap, SmallCap indices trade 3% down as investors rush to book profits

It’s just like the 2006-07 bubble in real estate and infrastructure—there was a very strong, fundamental case for real estate and infrastructure at that point in time as well. A billion plus Indians … all needed houses … roads and more infrastructure. The country has seen an upgrade in infrastructure, but many of the companies from the 2006-07 timeframe are no longer around, or at least not in meaningful size. But on the whole, the sector has not done very well—it went through very difficult times because prices were stretched to extraordinary levels. Similarly, right now, in some segments, some companies will do well over time, but a lot of the companies will be available at far lower prices than they are today.