Valuation concerns loom over small and mid caps — is it still wise to invest?

"Since the start of FY24, the Nifty 50 index has delivered 14.2 percent return, but it pales in comparison to the 36 percent+ return from the Nifty mid-cap indices and the 40 percent+ return from the Nifty small-cap indices. While short-term trends suggest investors are chasing momentum in mid- and small-cap stocks, a broader perspective reveals a different story," said Gopal Kavalireddi, Vice President, Research, at FYERS, a broker.

After a three-year period of underperformance from 2017 to 2020, FY21 and FY22 brought significant rewards to market participants. Mid- and small-cap indices outpaced the Nifty 50 by a significant margin. However, FY23 saw a shift in the trend, with the Nifty 50 and Nifty mid-cap indices delivering flat returns, and the Nifty small-cap 100 recording a negative return of 13.8 percent.

"Recognising the undervaluation in mid and small caps amid an improving economic environment, discerning investors reallocated their funds from large caps to the mid- and small-cap segments," Kavalireddi said.

AMFI data on equity fund flows since FY22 underscores this shift.

As per Kavalireddi, net flows into large-cap mutual funds dwindled from 8.2 percent of total equity net flows in FY22 to 5.7 percent in FY23, experiencing a 12.1 percent decrease in FY24 (April to August). In contrast, mid-cap mutual fund inflows surged from 9.9 percent to 19.2 percent, while small-cap fund flows skyrocketed from 6.2 percent to a remarkable 41.9 percent in FY24.

The stock market has seen a surge in investor participation in recent years, especially since the onset of the CIOVID-19 pandemic, with around three million demat accounts being opened monthly. As of August 2023, year-on-year demat account openings increased by 25.8 percent, reaching a total of 12.66 crore accounts.

Government reforms and an improving economic environment opened up new opportunities across sectors, enticing domestic and overseas investors to explore and invest in mid- and small-cap companies with growth potential and attractive valuations.

Factors like balance sheet cleanups, the implementation of the Insolvency and Bankruptcy Code (IBC), a lower interest rate cycle, divestment plans, government capex, and production-linked incentive (PLI) schemes and the like created opportunities in sectors such as railways, defence, electronics manufacturing, electric vehicles, green energy, and utilities, most of which were dominated by mid- and small-cap firms.

Between January 2021 and September 2023, the majority of the 129 IPOs listed on stock exchanges were from the mid- and small-cap categories, with a vibrant small and medium enterprise (SME) primary market.

With a broader selection of stocks available in the mid- and small-cap categories, investors realised that 97.5 percent of the market comprises these segments, leading to increased fund flows into these areas.

The question that looms is whether valuations are becoming frothy.

According to Kavalireddi, investors should approach this segment with caution, considering different strategies based on their investment horizon.

"While some segments have witnessed substantial stock price increases, particularly in capital goods, engineering, realty, metals, and public sector companies, investors should closely monitor the execution of order books. For long-term investors, tracking the implementation and execution of projects remains crucial. Short-term investors may want to ease off on fresh investments in sectors where stocks are well-priced or overpriced relative to earnings growth projections. Sector rotation is a common occurrence, and opportunities may emerge in under-invested and reasonably valued sectors such as financials, IT, pharma, consumer durables, discretionary consumption, textiles, and more," he said.

While large-cap stocks have a track record of consistency in returns, mid and small caps hold potential for wealth generation in the coming years. However, not all mid and small caps will thrive, so investors should carefully select stocks from sectors that are vital to India's economic growth, Kavalireddi added.

To navigate this high-risk, high-reward segment successfully, investors should adopt a strategic allocation policy for the core sectors and use a tactical allocation policy to seize timely corrections.