MC Explains | Why midcaps, smallcaps are burning brighter than Nifty50

Trigyn Technologies | CMP: Rs 115.65 | The stock rallied more than 6 percent after its subsidiary Trigyn Technologies, Inc has received an enterprise task order agreement for providing citywide systems integration services, Class I, from the City of New York (City), Department of Information Technology & Telecommunications. The order is for six years.

Stock valuations are not cheap anymore, a fact that has pushed many investors to the sidelines and wait for a dip to enter the market. Some believe now is the time to book profits so they can deploy the proceeds when the market corrects.

Any potential market correction hereon will probably be because of the hawkish tone of the US Federal Reserve on interest rates to control inflation and stagflation worries in the world’s biggest economy.

At such a point in time, smallcap and midcap indices have outperformed the benchmark Nifty50 of the National Stock Exchange and the BSE Sensex.

Let us dive deeper into the reasons why the broader market has outperformed headline indices.

How much has the broader market rallied in comparison to the headline indices? 

Both the Nifty50 and Sensex have fallen 1 percent in the past month. The Nifty Midcap 150 has surged over 3 percent and the Nifty Smallcap 250 has jumped 6 percent during the same timeframe.

Why has the broader market risen and what has capped the gains in headline indices? 

In the first leg of the rally, from July 6 to September 13, when the Nifty50 rose to 18,000 from 16,000, gains largely came from largecap stocks.

A month back, when the Nifty was around 17,800, only 4 percent of the stocks in the index were trading below the 200-day moving average (DMA). In the Nifty midcap 150 index, 50 percent of the stocks were below the 200-DMA and in the Nifty smallcap index, it was 82 percent, according to a wealth manager.

This showed that smallcap and midcap stocks were still struggling to find momentum despite the runup in the Nifty, which means that the rally was not broad-based, he said.

Now that largecaps look overvalued, the market is moving towards buying stocks in the midcap and smallcap space that offer a decent upside potential.

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What is the reason for the outperformance of the broader market or the underperformance of headline indices? 

Valuations of several largecap stocks looked stretched while most midcaps and smallcaps still looked attractive. This triggered a rotation of money into midcaps and smallcaps, which powered up the Nifty midcap 150 and Nifty Smallcap 250 indices.

Basically, the outperformance was because investors hunted for growth stocks at a time when bluechips were in the overbought zone.

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Will the broader market’s outperformance continue and what is the market outlook? 

Midcaps and smallcaps are expected to continue their outperformance trend in the short to medium term.

Currently, the Nifty smallcap trades at 17 times the forward price-to-earnings (PE) and the Nifty midCap at 23 times forward PE, while largecaps trade at 19.6 times forward PE. Midcap valuations seem slightly stretched as historically small and midcaps used to trade at a significant discount to largecaps, the wealth manager cited above said.

A section of the market believes that India is in a sweet spot due to the revival of its capital expenditure cycle and will continue to attract foreign and domestic inflows.

Many large corporate entities have set out on a capacity expansion spree. Banks are in better health now and capitalised to support credit growth in the economy, analysts said.

Along with the revival in the capital expenditure cycle, the earnings cycle of Indian companies is also seen reversing.

Also read: Fund managers most bullish on auto stocks in over 4 years

“India’s earnings cycle has seen a turnaround after almost a decade and continues to remain healthy, amid the current adverse macroeconomic scenario with heightened worries on rising interest rates, elevated crude oil prices and liquidity tightening that has kept the market volatile and jittery,” Motilal Oswal Financial Services wrote in a recent note.

Motilal Oswal has estimated that net profit in FY22-24 will grow 17 percent compounded annually with a rebound in battered sectors.