Midcaps fall sharply after Kotak calls rally an 'irrational exuberance'

According to Amit Jain, who co-founded Ashika Global Family Office Services said, currently, smallcaps and microcaps seem overvalued compared to their growth potential

After a remarkable run for several weeks, midcaps and smallcaps went into a correction mode today recording steep falls, a day after Kotak Institutional Equities called the rally in midcaps “irrational exuberance”.

In a report titled, Mad (-cap) Dash, analysts at Kotak Institutional Equities said they saw limited point in trying to find fundamental reasons behind the steep increase in stock prices of several midcap and smallcap stocks.

There is no meaningful change in the fundamentals of most companies; in fact, they have worsened in many cases, the report noted. “The primary driver of the rally appears to be irrational exuberance among investors, with high return expectations (and purchase decisions) being driven by the high returns of the past few months.” Kotak said.

In today’s trade, the NSE Midcap index fell 2.62 percent, while the Small-cap index fell 3.4 percent.

Kotak noted that non-BFSI stocks are trading near their 12-month fair values, and sectors like capital goods, healthcare, QSR, and real estate are already priced for future growth, with little room for error. To maintain portfolio integrity, they had to remove these stocks, leaving mostly BFSI stocks.

Several stocks in the portfolio surged in recent months, forcing frequent changes by Kotak.

‘Irrational exuberance behind the rally’

Kotak believes the sharp stock price hikes are driven by irrational investor exuberance in the midcap and smallcap market segments.

"We see limited point in trying to find fundamental reasons behind the steep increase in stock prices of several mid-cap and small-cap stocks. There is no meaningful change in the fundamentals of most companies. In fact, they have worsened in many cases. The primary driver of the rally appears to be irrational exuberance among investors, with high return expectations (and purchase decisions) being driven by the high returns of the past few months," Kotak said in its latest note.

While sector fundamentals remain stable, exuberant market sentiment is evident through soaring stock prices, increased investments in mid-cap and small-cap mutual funds, and a growing number of retail investors in these segments. The strong performance of these indices may have raised return expectations of retail investors, it said.

Emergence of new favourites

The brokerage house said that though institutional investors' traditional mid-cap stocks in the consumption sector have lagged behind in the current mid-cap rally due to weak demand, their valuations still remain high. Risks include lower profitability and valuation multiples due to weakening business models.

On the other hand, new favourite midcap and smallcap stocks are in the investment sector, like capital goods, defence, and real estate. They are showing impressive returns. However, concerns exist regarding their historical execution and governance records, especially as many operate in the B2G or B2B sectors. Market expectations for revenue and profitability might be overly optimistic.

Lastly, some midcap and smallcap stocks fall in the 'turnaround' category, despite recent operational and financial challenges. The basis for market confidence in their future performance is uncertain, it added.

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