The great Smids rally: Who’s at risk?

“A 10% plus correction after such a stupendous rally in Smids isn’t abnormal. But I believe the structural story in areas like renewables is intact,” Verma said.

A retail investor, who like most of his ilk hunts for eye-popping returns in the Smids space, Verma lapped up Inox Green Energy Services and KPI Green Energy sometime in April this year, when the current rally gathered pace. Since April, the Inox Green share has delivered an 85% return while KPI Green returned 60%.

Inox Green is a wind power operation and maintenance services company. KPI Green Energy is a solar power producer.

Verma doesn’t plan to offload his shares yet, but won’t add more. “For me, the alarm bells will ring only if there is across-the-board selling, an election upset, or if corporate governance issues crop up in a particular stock I hold, and I don’t envisage such events,” he said.

By elections, he means India’s general election, expected to be held between April and May next year.

Many believe that a pre-election market rally is already under way. However, a disappointing election outcome can play havoc. Many mature retail investors, like Verma, understand that. Recently, global brokerage firm Morgan Stanley stated the same. Morgan Stanley’s base case is for the National Democratic Alliance (NDA), led by the Bharatiya Janata Party (BJP), to win the 2024 general elections. It believes that the markets have priced in the BJP winning 260 plus seats. If this indeed happens, the Sensex could rise by 5% in three months after the elections. If, however, the NDA loses and a weak coalition forms the government, the Sensex could tank by as much as 40%, the brokerage firm believes.

There are other retail investors who believe that the market is “hot”. An executive with a family office in Mumbai, who didn’t want to be identified, has offloaded part of his holdings in stocks such as International Conveyors, Kirloskar Pneumatic and Kirloskar Electric after deriving over 2x returns on them.

International Conveyors is a manufacturer of belting systems while Kirloskar Electric is a manufacturer of electrical and electronic equipment. Kirloskar Pneumatic is a diversified manufacturer whose products range from air conditioning to transmission systems.

Stocks like International Conveyors and Kirloskar Electric, with total market cap between ₹500 crore and ₹700 crore, have generated a return of 65-75% in the past five months. This coincides somewhat with the present market rally from 20 March through 12 September— it catapulted the Nifty Midcap 100 and the Nifty Smallcap 100 by 35% and 38%, respectively, or two times the Nifty’s relatively modest 18% rise to 19,993.2.

Typically, companies with a market capitalization of up to ₹5,000 crore are called small-caps. Mid-cap ranges from ₹5,000 crore- ₹20,000 crore, while large- cap are companies with a market capitalization of above ₹20,000 crore.

“If you ask me whether the Smids market is ‘hot’, I’d say yes, but I don’t think this market has topped yet. There’s more steam left though short-term corrections can’t be ruled out,” the executive said.

But not all retail investors are as seasoned as the two executives we mention above. And the data is a tad alarming.

Retail investors are of two kinds—those who invest indirectly through mutual funds and those who prefer a direct route, buying and selling using their discretion through brokers.

In 2023-24, most of the retail investors who directly accessed the market began investing in the National Stock Exchange (NSE)’s secondary market only in August, when the market was already quite heated. Market veterans believe that the phenomenon known as the ‘fear of missing out’, or FOMO, is at play and might have added to the irrational exuberance being witnessed in stocks which comprise the Nifty Midcap 100 and the Nifty SmallCap 100.

While retail at large could be at risk of a steep and sudden fall, those investing directly are more vulnerable. They are in a zone of danger. A majority of these direct investors, in contrast to their peers who trade through mutual funds, have hopped on with the view to simply play the momentum.

Before August

What caused the rally before August in the first place?

A gross domestic product (GDP) growth of 5%-6% is considered good for Smids, while large-caps need a consistent 8% GDP growth to outperform. India’s real GDP growth for April to June this year has come in at 7.8%. This is the highest in four quarters.

While the economy’s current growth rate appears to be ideal for Smids, the rally resulted from institutional flows on the back of the Indian government’s thrust on infrastructure and capital expenditure plans of ₹10 trillion in 2023-24. Good corporate earnings only added to the momentum.

Shares of companies in the industrial, capital goods, and renewable sectors picked up pace. Mutual fund managers, suddenly, were flush with more money coming through the systematic investment plans of mid-cap and small-cap schemes. The net assets under management of mutual funds’ mid-cap schemes, as of August 2023, stood at ₹2.39 trillion, up 34% from a year ago; small-cap schemes grew by a whopping 62% to ₹1.94 trillion.

“Retail investors still tend to redirect investments to the best performing categories and funds. In line, the initial streaks of outperformance by mid-caps and small-caps a couple of months back prompted a substantial influx of investments into funds focused on these market cap segments,” said Nirav R Karkera, research head at Fisdom, a financial services company. “Consequently, these investments were further deployed into the same universe of stocks. Such reasonably large investments into the segment have been a catalyst for further run-up,” he added.

In the case of mutual funds, the Association of Mutual Funds in India defines mid-cap as 101-250 stocks after the first 100 measured by market capitalization. Small-cap ranges from 251 to 500.

What numbers say

Some investors, like we mentioned earlier, believe that the Smids market hasn’t topped out yet. There are some numbers to back this view.

The Nifty Midcap 100—Nifty ratio reflects the number of times the former trades at, to the benchmark. The Nifty Midcap 100 will top out when the index trades at 2.3 times to the Nifty, according to technical experts. At present, it trades at around 2.01 times. Similarly, the small-cap index will top out when it trades at 0.84 times to the Nifty while presently it trades at 0.6 times.

In short, the multiple that Nifty Midcap and Smallcap trade at to the Nifty is still away from the peak—therefore, the rally that picked up in March might have more legs.

The last time the mid-cap index ratio bottomed was in March 2020 (1.35) with the onset of the pandemic. It has risen to the current level of 2.01 since. The story is similar when it comes to the small-cap index ratio.

Warning signs

Data from the NSE shows that on a net basis, retail investors who trade directly sold shares worth ₹70 billion in the current fiscal year through August end. The figure would have been higher had they not invested ₹144 billion in August, after selling ₹214 billion from April- July.

“For a retail investor coming directly, it looks like FOMO,” explained Nilesh Shah, managing director at Kotak Mahindra Asset Management Co. “If one looks at the 150 mid-cap stocks and 250 small-caps as defined by Sebi, mutual funds, as of last month, through their various schemes, held around a fourth of mid-caps and a little less than a fifth of small-caps by free float market cap value. Indirect retail is largely better off than retail investors who missed much of the run up since March 20,” he added.

Free float refers to the shares of a company that can be publicly traded.

While direct retail might have hopped on only in August, mid-cap and small-cap schemes alone have attracted inflows of ₹28,243 crore in the fiscal year through August, up from ₹16,098 crore over the same period last fiscal.

“Those who have come because of FOMO and to play momentum are in the danger zone. Investing is serious business and requires a highly disciplined approach,” Vijay Kedia, a veteran investor who specializes in identifying potential multibaggers in the Smids space, said.

One warning sign is the discontinuation by Kotak Institutional Equities (KIE) of its model mid-cap portfolio, which comprised the likes of Aavas Financiers, Colgate-Palmolive, Federal Bank, Max Health Services and Max Healthcare, to name a few.

“We are dropping our recommended mid-cap portfolio since we cannot find too many stocks beyond the BFSI (banking and financial services) space that offer decent potential upside to our 12-month fair value,” KIE noted in a report dated 11 September. Fair value refers to the price of an asset agreed upon by both buyer and seller.

Another fund manager said that if mutual funds feel that exuberance is rising, they could simply stop subscription to a scheme.

In the recent past, Chandraprakash Padiyar, fund manager of Tata Small Cap Mutual Fund, took a call to temporarily stop accepting further lump sum investments into the small-cap fund. Padiyar told Mint earlier that the heavy inflows in the last couple of months made it difficult for the fund house to deploy additional funds without driving up stock prices.

The largest small-cap fund, run by Nippon India Life Asset Management, has also halted fresh inflows with effect from 7 July, pointing to the difficulty in deploying funds.

Who moved the price?

Valuations in the present rally have soared to stratospheric levels especially in stocks with low free float. This makes many constituents in the Smids segment vulnerable to huge volatility. A one-day fall can wipe out trillions of rupees in investor wealth as 12 September’s 3% fall in Nifty Midcap 100 and 4% fall in Nifty Smallcap 100 showed.

Normally, these segments attract high net worth investors (HNIs), proprietary traders, retail, and to an extent, domestic institutional and foreign portfolio investors.

In companies like Rail Vikas Nigam (RVNL), one of the top five small-cap performers in the 20 March to 12 September rally, the free float market cap was worth just ₹7,821 crore or 22% of the total market cap as of 12 September. RVNL is a public sector company under India’s ministry of railways. Total market cap includes shares held by both promoters and the public.

Similarly, the free float market cap for Fertilizers and Chemicals Travancore (FACT), another top small-cap from the public sector, was just ₹3,222.4 crore (10% of the total market cap).

Both RVNL and FACT are still part of the Nifty Smallcap 100 Index even when they have a far higher market capitalization now. NSE Indices, a subsidiary of NSE, determines the inclusion and exclusion of stocks into broad market indices semi annually, in March and September. In this September’s review, RVNL and FACT have been excluded from the small-cap index and moved to the Nifty Midcap 150 effective 29 September.

A stupendous increase in the price earnings (PE) ratio of these stocks gives an idea of the run up. For example, RVNL’s PE stood at 24.16 times (price of share traded 24 times more than the earnings per share) against the historic 10-year average of 8.11 as of 12 September, according to Bloomberg.

“Low free float means a few strong hands (HNIs) can move the price of any small or mid-cap stock exorbitantly,” said Deven Choksey, managing director of KRChoksey Holdings, a wealth management company. “Seeing such momentum in the price, retail investors looking to make a quick buck are lured in. When the tide turns, and HNIs book profits, retail is left high and dry,” he said.

While stocks in renewables, railways, capital goods and defence sectors have performed exceedingly well, thanks primarily to the government raising its capital expenditure plans in 2023-24, KIE, in its 11 September report, noted that market expectations on both revenue and profitability may be very optimistic.

“We expect a decent investment cycle, but we are not sure about the quality of many of the stocks, given their historically weak execution and governance track-records. In addition, many of these sectors fall in the B2G (business-to-government) or B2B (business-to-business) categories, which raises issues around execution and profitability,” the report stated.

This reads like a stark warning—a warning retail investors should heed.