Time To Be Cautious About Some Smallcap And Midcap Stocks: HDFC Sec Report

Smallcap and midcap space..is it time to be more selective?

Stock prices of many small and midcap companies have risen over the last two weeks anticipating a significant improvement in their future cash flows. While some of them have good Q4FY21 results as tailwinds, some others are relying on policy changes at the local or global levels as triggers for improvement. Having said that, the prospects of most of these recent high flyers may not have changed dramatically which can justify a sharp jump in their stock prices in such a short span of time.

When we look at data of last few sessions on the exchanges, we find speculative interest is rising fast. Proportion of turnover in non-A group shares (A group has 387 stocks) on the BSE has risen from 32% to 45%. Most of these trades are not resulting into higher investments as Gross deliverables % has gone down from 43.2% to 40%.

 Many times, markets anticipate future cash flows too early and discount them before the actual improvement on the ground. After a sharp surge, stocks prices do correct or consolidate while fundamentals catchup with higher valuations. For example, after a stupendous run in the year 2020, Nifty Pharma index was trading at the same level in March 2021 as it was in August 2020.

 The following is the list of 20 better known mid and smallcap stocks that have gained more than 20% in this period. 17 out of these 20 stocks belong to the Chemicals/Pharma space. The recent positive trigger in this space is due to China+1 strategy adopted, commodity price uprun and Covid-19 related demand upsurge. All companies may not benefit out of this equally.

Traders have a tendency to buy stocks of a happening sector, assuming that the triggers present in the best performing stock may percolate to others in the same sector. Some of these companies will sustain and grow from these levels also but most stock prices have probably run up ahead of time and may correct/ consolidate for a long time before rising further.

 Liquidity/depth is an important parameter to keep in mind while investing in this space. Currently, existing investors are holding on to their stocks and refusing to sell them in the market in anticipation of even higher prices. Low floating stocks means as new money pours into this space, stocks zoom higher in a short span of time.

 FPIs have sold stocks worth Rs.12014 cr in the April month so far. Mutual funds have so far bought stocks worth Rs.4173 cr in this month. Hence the buzz in the small and midcap space can be attributed largely to retail/trader interest.

 Technological disruption and speed of change has accelerated in recent times and that may make many today’s successful business models irrelevant in times to come.

 Many of these small companies are not widely researched and few research analysts track them. We have seen many precedents of investors burning their hands in small and unknown stocks especially in companies where corporate governance standards are not up to the mark. We recently saw midcap and small cap index losing as high as 51% and 67% from their respective top to bottom between 2018 to 2020.

 At the same time, early investment in a successful mid cap and small cap has the potential to generate significant excess returns. But for that enough study, analysis and due diligence is necessary.

 The Nifty may not have made a high and hence there may be scope in smallcap and midcap indices to rise further. However stock selection is paramount and later taking a call on full or partial exit at appropriate time is equally important. The upmove from here in small and midcaps may be led by some new sectors.

 Be careful of what kind of stocks you are entering now. One should calibrate your exposure in select midcap and small cap stocks as per your risk appetite and asset allocation plan. It is a good idea to accumulate the selected stocks via SIP mode rather than putting large amount in a stock in lumpsum at one go. Refrain from buying small and midcap stocks just based on hearsay/tips or momentum in the sector.