Mid and small cap stocks – is it time to exit?

Last week, brokerage Kotak Institutional Equities published a report in which it cited irrational valuations and a withdrawing of its midcap and smallcap model portfolio. The mid and small caps indices saw sharp sell-offs in the immediate wake of the report. 

This drop was short-lived and the brokerage later come out with clarifications on its stance. Even so, the over-arching point of the report on valuations in the mid-and-small cap segment remains and has sparked plenty of concern over continued investments in these segments.

So – should you be scaling back and exiting the mid-cap and small-cap stocks and funds in your portfolio? In this report, we break it down as follows:

• The concerns highlighted in the Kotak report
• What the mid-cap and small-cap space offers in terms of opportunity
• What you should do now

Mid and small caps – valuation concerns

We’ll set aside the clarifications made by Kotak Institutional Equities about the report. The reason is that the data contained in the report do highlight valuation concerns and raises valid questions, which we will discuss here. The report, categorised stocks under three broad categories:

Great history, bleak future

Mediocre history, purported future and

No history, no future 

Under these three categories, it classified companies quoting at irrational valuations from sectors such as consumer discretionary, defence and railways, electronics manufacturing, capital goods, renewables, etc citing various concerns. It could be fading away of “moats” in certain categories, it could also be the B2B nature of business that demand high capital investment in some other categories, and single buyer risk in categories such as defence and railways. These are valid concerns that investors must take cognizance of.

The data from the report also points that only 25% mid-cap stocks out of Midcap 100 have seen more than 50% rise in the last 6 months while this ratio is 50% in case of small-caps.  

The phenomenon of irrationality in valuations is NOT new to markets. To put in a better way, this is how market works. We have discussed this earlier on how “peak valuations at peak earnings” create traps for investors.  

At the same time, the mid and small cap segment in their entirety cannot be painted with the brush of irrational valuations. This is also the space where opportunities exist for investors to pocket smart long-term gains by spotting winners early in their lifecycle. 

Therefore, two points summarise our view:

• One, the current exuberance in the mid and smallcap segments and the manner in which it has shrugged off the negative sentiment calls for caution especially in direct stock investments, and thorough research.
• Two, there is no need to exit these segments and it is important that your portfolio – whether funds or stocks – have representation from this space. We say this not just in terms of the higher return that goes with midcaps. It is more that opportunities to tap the India story and the new themes are more in the mid-and-smallcap space. 

We explain these points above in the next section of this report.

The mid and small caps opportunity 

There are 3 reasons why mid and small caps as a category is important to play the India opportunity.

#1 Elephants can’t dance with ease

There will be a limit to the returns that you can expect from the index stocks and large caps (or safe bets).  Returns have significantly moderated in the last 15 years from the 18-20% that we used to talk about a decade ago to 11-15%. 

If we look at the Nifty composition, large financial stocks have a 37% weight followed by 14% for large IT services companies and 10% for FMCG. This is almost two-third of the index and these categories largely represent companies that are highly attached to domestic or global GDP growth rates. Financials may grow at or lower than 1.5 times nominal GDP growth rate, FMCG may be equal to or lower, while IT Services is attached to a much-lower global GDP growth rate. 

The Nifty has also seen the addition of a few conglomerates or behemoths such as Adani Enterprises and LIC – and these don’t make for much superior growth, either.   

It is true that the Nifty 50 rallied 60% post-Covid (Vs pre-Covid). But that has largely come on the back of re-rating in earnings from the financials basket. To put in perspective, SBI reported a loss in FY19 while it reported over Rs.50,000 crore in profit in FY23. A similar story plays out in corporate banks such as ICICI and Axis. Reliance Industries also saw a one-time re-rating through value unlocking in JIO Platforms and Reliance Retail. 

All put together, the Nifty 50 delivered ~13% CAGR in the decade between 2013 and 2023. But if we take the last 15 years since the global financial crisis, it falls to 11% as the period between 2008 to 2013 has not seen any returns. 

This return picture may not change materially with the current index composition unless more high growth categories emerge, with significant weights, in the Nifty 50.  

#2 A lot of the next $3.5 trillion opportunity may be outside the index

As explained above, the large-cap basket is lighter on higher-growth segments. But why is this an important point? 

As the country adds another $3.5 trillion to its GDP in the next 6-7 years, growing at a nominal rate of 11-12%, there could be many opportunities unfolding for the investors. 

While India is already the 5^th largest economy in terms of GDP, it is still far lower in terms of per-capita GDP compared to the next 5 economies in the order of GDP. But the next decade and beyond could see India moving up on this key parameter – leading to unlocking many investment opportunities for investors as new sectors open up, smaller sectors expand, and newer opportunities change prospects for others.

Consider themes like China+1, import substitution of electronics, and discretionary consumption. These are largely outside of top-50 or top-100 stocks at this point. For example, it is only recently that PI Industries, one of the largest contract research and manufacturing companies from non-pharmaceutical space entered the large cap category. This R&D based manufacturing, in agri or pharmaceuticals, is one of the largest opportunities in the China + 1 theme. This space is also attracting significant private equity attention at this point of time.

In discretionary consumption, a handful of stocks show the potential as a stock travels across the marketcap range or clock revenue and profitability profiles to rival large-caps. One example is Varun Beverages where it was a small-cap beverages player which graduated to mid-caps and then large-caps over the last 5 years, triumphing mid-tier FMCG players in market cap. This player scores on revenue and profitability as well. 

The largest fashion player by market cap, Trent has bridged the gap with mid-tier FMCG players to become a large cap, growing its sales ~2.5x from pre-Covid levels, something that FMCG players can’t aspire to do. A premium 2-wheeler manufacturer graduated from small cap to mid cap and to large cap in last decade, and sits at a decade-high in sales volumes even as the 2-wheeler industry sales is hovering at a 9-year low. E-commerce has democratised the difficult-to-build pan-India distribution and has led to the birth of new companies and online platforms in various consumer categories.  

While these are examples of what has already transpired, this trend of new category creation and companies graduating higher in the market cap order, and which belong to categories outside the Nifty 50 basket, is likely to continue with economic expansion and increasing per-capita income.  

It’s not just currently listed sectors or mid-and-smallcap stocks that present opportunities that cannot be found in largecaps. Whether owing to government policies that encourage sectors, or a better listed environment, smaller sectors could see more activity in the listed space. For example, mobile phones and electronics stayed outside the listed space for long until investors got one – Dixon Technologies. But changing Govt. policies in this sector could open up more players, including home-grown brands (like BOAT, proposed IPO), which could start reflecting in the listed space as well. 

Beyond these categories, we are also seeing companies moving significantly up the value chain in this changing world.  Specialised IT services companies are becoming strategic partners for global automotive companies, component players are graduating to product and systems players or engineering companies are moving up the value chain to become defence players.  

Newer category creations, newer opportunities and moving up the value chain can help companies graduate from small caps to mid-caps and mid-caps to large caps over time. 

#3 India is not one market, but a sum of many

India is NOT a single unified market for many goods and services. From regional banks to consumer companies to healthcare service providers, many cater to only parts of the  Indian market and not pan-India. There are several reasons for this – varying income levels that prevent some companies from expanding pan-India, the culture and preference in some product categories, and rules & regulations as well as regional competition in others.   

So, why is this important? 

Because it means there are region-specific opportunities, which are more likely to be found in mid-and-smallcaps than in large caps. 

This makes small and mid-caps a good playground for investors to tap micro-opportunities, and participate in the growth if these companies eventually scale up nationally. Some of these companies are utilising their capital judiciously by taking a cluster-based approach, eventually targeting to cover the whole of the country while others are taking the M&A route to become national players.  

To put more clearly in perspective, let’s discuss few sectors that are largely mid-cap and small cap regional plays while still providing qualitative investment opportunities:  

• The sixth largest bank in terms of advances, Federal Bank is still a regional bank with its roots in South even as it delivered 18% CAGR return in last decade. The two small finance banks, Equitas and AU, that have just turned larger than their regional banking peers in market cap, are regional players with one operating in West and other in South.  
• Most of the listed housing finance players, especially the ones catering to affordable housing such as Aptus, Aavas, Home First and Canfin, are regional players only.  
• In India, there are only 3 pan-India cement players (Ultratech, Shree, ACC & Ambuja post Adani’s acquisition). The 4^th, 5^th and 6^th largest players (Dalmia, Nuvoco and Ramco) by capacity as well as market cap are only regional players, and they are all still mid-caps and small caps.  Still, they are not far behind the larger ones either in terms of operating efficiency or in terms of value creation to shareholders.
• The top two diagnostic players, Dr. Lalpath and Metropolis, have North & East and South & West, respectively, as their focus geographies. Investors don’t have a choice other than to buy both if the intend to play the pan-India opportunity in this space and a famous PMS manager has chosen this strategy recently.
• In healthcare services/hospitals, where there is only one pan-India player, Appollo, while others are mainly regional players (be it Max, Aster, KIMS, Narayana or Global Health) with significant geographical concentration. 
• There is only one national jewellery player, Titan, in an industry that has been traditionally regional, for decades. The second largest player, Kalyan Jewellers, is a regional player and has graduated to a mid-cap from a small-cap, and there are a few purely-regional players like Thangamayil, TBZ and Senco (recent IPO) that are small caps.  
• India’s largest listed amusement park player, Wonderla, is a South focused player while the country is yet to move up the affordability curve to have a Disneyland. This player has delivered 19% CAGR since its listing a decade ago.
• Most of listed dairy companies such as Hatsun, Heritage and Dodla are South based where corporates have replaced co-operatives. This can continue as a regional play as they could be challenged by country’s largest co-operative in geographies such as North and West.  
• The second largest QSR player by market cap, Westlife Foodworld, is a West & South only (due to Mc.Donald’s license restrictions) player and not a pan-India player. We are also seeing snacks companies such as Bikaji and Mrs. Bectors getting listed (Haldirams is readying for IPO) which are mainly regional and may stay so due to regional tastes and preferences.   

This regional focus may not act as a limitation for companies on growth and scalability due to the size of each geography.  To put in perspective, just the Southern States could be a $ 1 trillion economy in the near-future – which is the size of some other entire economies! – and hence offer scalable and profitable opportunities for companies focused on these regions. The West & North comprising Maharashtra, Gujarat and NCR could be another $1 trillion economy. 

In addition, several regional companies with capable managements are taking/may take the M&A route to become national players thereby offering a long runway of growth for investors.  

For example, ACC and Ambuja Cements were regional cement players that came together to become a pan-India player under an MNC. Large private banks have used this M&A route in the past to become the national players they are now. A north based mattress maker (Sheela Foams, Sleepwell) has recently acquired a south based player (Kurlon) to become a national player. A South-born small appliances player (V-Guard) acquired one in North (Sun flames) to establish its foothold there, while a North-based player (Crompton) acquired one in the South (Butterfly) with same intention. Several such strategic M&As are happening in the consumer space including foods & beverages as well. 

This sum-of-many-parts nature of our country makes mid and small caps extremely relevant for investors, especially in categories where there is huge runway for penetration-led growth. 

Way forward

The need to have mid-cap and small-cap stocks in a portfolio is well-established, based on the points above. However, valuations certainly cannot be ignored, nor the fact that the mid-and-smallcap space houses plenty of poor companies. In this space, especially in the current market scenario, you need to separate the wheat from the chaff – that is the only way you can minimise the risks of investing in expensive stocks or poor-quality ones. 

Out of the 2,000+ NSE listed companies, only the top 100 are classified as large cap. The remaining fall under the mid & small cap categories. The market cap of the 100^th stock is around Rs.50,000 crore while that of the 250^th one is around Rs.17,000 crore; this comprises the mid-cap stock basket.  

The remaining are all small caps. The 500^th company has Rs.5,000 crores market cap and companies until this market cap make up for the famous BSE 500 broad based index. Small caps comprise 1,750+ stocks.

#1 Mid caps – a deeper look

A quick look into the valuation picture of the entire midcap universe using our stock screener shows their average PE at 44 times and average price to book comes to 6 times. 

Excluding financials, the PE jumps to 48 times and price to book to 7 times, a definite sign of stretch. A tenth of these are also quoting at PE multiples of over 100. 

Scary? But there is a silver lining. The overall valuations of this space must be looked at from the point of view of the margin pressures non-financials had to go through in FY23 while financials went through an opposite cycle (margin and profitability expansion). This also makes valuation optically cheaper for financials while expensive for others (Vs their own historical valuations). Market has also upheld higher multiples for companies where growth visibility is much higher. 

To cite some examples, stocks such as United Breweries, Voltas, Kansai Nerolac, Whirlpool, MRF, Hatsun Agro, cement companies, etc look expensive as they are yet to recover their margins as compared to their historical averages.  The mid-cap IT stocks as a basket, on the other hand, refused to cool-off on valuations as their growth resilience forced market to pay higher multiples. Scarcity premium is also attached to stocks like Syngene, Dixon, Metro Brands, Escorts, Tata Elxsi, etc for what they offer in terms of growth combined with quality of growth. 

Here are checks that you need apply in choosing mid-caps

• Approach order book stories and cyclical businesses quoting at rich valuations with scepticism. Don’t go by PE for pure-play commodity businesses – metrics such as EV/ EBIDTA work better. Similarly, Price to Book may work better for PSU financials. 
• Don’t chase cyclical businesses quoting at cheap PE as cyclically high earnings may make their PE look optically cheaper. This can be gauged by looking at their EBIDTA margins vs their historical average and the recent spike in profitability. 
• Go with established consumer franchisees where margin recovery is yet to play out while having an eye on their fair valuations (on full margin recovery compared to historical averages) vs their potential earnings and growth rates. 
• Approach new consumer franchisees ,with limited operating history, with scepticism and steer clear of them if their PEG ratio is more than 2.5 times. 
• Give the benefit of doubt to richly-valued, but scalable monopolies/ duopolies/ high market share players if the chance of new entrants are low in those sectors.

The bottom-line is that extreme valuations are a matter of how the market itself works. Growth, quality of growth (RoCE) and longevity of growth (moat) are the three things that market cares for in pricing. Ones with a mix of three won’t come cheap unless they slip on one of these. For investors, the difficult task may be to figure out “what price to pay” for a business. 

The ones with mediocre history, bleak future or no future are definitely the ones to be approached with extreme caution.

#2 Small caps – cut down the tail

Everything after the first 250 stocks by market cap comes under this category as per SEBI definition. The trap gets bigger down the order due to poor management quality and limited track record of profitable growth. 

While the Nifty Smallcap 100’s 22.7 PE and 3.6 PB may look reasonable, it is not representative of the small-cap universe given the number of companies outside the index.  Therefore, an initial quality filter is extremely useful in narrowing down the list. 

Here’s how you can use our stock screener: 

• Set the market cap range between Rs.500 crore and Rs 17,000 crore 
• Set minimum RoCE and RoE at 15% using the “3 year average” quality filters which will simply weed out mediocre companies. 
• Use the quality filter “No. of years of positive cash flows” to select companies with at least 2 years of positive cash flows in the last 3 years. 
• These three filters weed out over 1500 stocks out of total 1,750+ NSE listed small cap stocks
• Finally use the “Promoter pledge” filter from the Ownership filters to further weed out ones that are susceptible to manipulations or shocks 

The output is a list of 270 companies with reasonable quality and most are above Rs.1,000 crore in market cap. The list comprises high-quality names including MNCs and sector leaders (where the sector itself is small) as well as ones with strong recall for their business/brands. The average PE for this basket is 32 times while the average price to book is 6 times. 

You can view this list here. 

You can additionally make use of other filters in our stock screener to further filter out stocks based on growth and valuation parameters. Other premium screeners can also be made use of to gauge the recent trends on earnings growth, margin expansion and debt reduction.

As with the pointers in the mid-cap basket to separate out the ones which can be looked at for investment, the same will apply here.

What to do 

To summarise all that is explained above, the mid-and-smallcap segments are getting more relevant for higher return potential than before, but require caution both because of their high-risk nature and because of the market run-up. 

If you are a stock investor, you have no choice but to put in a tremendous amount of work in analysing and understanding the companies and their industries, and you will need some amount of experience here. With the rally in these stocks, it is very easy to be drawn to wrong choices. 

• If you directly hold stocks: You need to look at these and decide whether valuations have run up enough to book profits or even exit to preserve returns. In other stocks, you can continue to hold, but avoid increasing exposure in order to minimise risks if a correction sets in. In Prime Stocks, we are shifting several of our picks to holds and will also look at exits in this same light.
• If you want to buy stocks afresh: You can run the checks explained above to find the reasonably-valued or high-growth stocks in the mid-cap or small-cap universe. We will encourage you to use our super-easy Stock Screener tool for this purpose. If you are adding these stocks now, be prepared for corrections. You can also create a shortlist of potential candidates, closely track them and invest when the price is right. Consider setting aside some ready surplus to quickly deploy is such shortlisted stocks or average costs on stocks you already invested in.

Such detailed effort is not easy for most. If you still want to participate this marketcap segment, then take the mutual fund route. With mutual funds, here’s how your approach can be. 

• If you already hold mid-and-smallcap funds: There is no reason to exit your investments; market cycles are par for the course and you need to weather corrections. Remember that these investments are meant only for portfolios of at least 5-7 years. However, what you can do now is to compare the allocation of these funds now in your portfolio and the allocation you want. If the allocation now is higher, bring it back to the intended allocation – this will help you book profits and take advantage of the mid-and-smallcap rally. This way you stay invested while taking some money off the table. If you don’t know what allocation to maintain, a rough ballpark is 25-35% at the highest risk level with a 7+ timeframe. Change this based on your own risk appetite and timeframe. 
• If you want to invest in mid-and-smallcaps now: Don’t go all-in right away. Either use SIPs for at least 12 months, or keep aside surplus and invest in tranches based on market movement. If you are running a very-long term portfolio, continue your SIPs and don’t consider stopping based on market reports. The idea of SIP is to anyway buy more on dips. Don’t curtail that process. 

Equity investing is a “time” game rather than a “timing game”. One can’t aspire to be smart to get-in and out on time easily and pocket gains always. What will eventually work is having a sound investment philosophy, a research process and an allocation discipline while “staying in the game” .

The securities quoted are for illustration purposes only and are not recommendatory.