Has the Froth in Small Caps Settled?

The regulatory warnings notwithstanding, small-cap stocks in India have continued to march ahead. In fact, the small-cap segment has been the best-performing category in Indian stock markets in the last one year. As of April 29, the Nifty Smallcap 250 has given a one-year return of 68.5%, compared with 59.9% for Nifty Midcap 100, 44.0% for Nifty LargeMidcap 250, or 25.3% for Nifty 50.

The sharp rise in small-cap stocks had the regulator worried about a sudden reversal and its impact on small investors, with the Securities and Exchange Board of India Chairperson Madhabi Puri Buch in March issuing a warning that there were “pockets of froth” in small and mid-cap stocks. The SEBI chairperson warned that there appears to be an “irrational exuberance” which is “not supported by fundamentals”.

“It may not be appropriate to allow bubbles to keep building because when they burst, they impact investors adversely,” Buch was quoted as saying. She even went as far as to say that SEBI is open to allowing mutual funds to hold more large-cap stocks in their small-cap portfolio to manage risks.

Even the Reserve Bank of India weighed in on the issue. “Stocks are riding an intense bull market - notwithstanding intermittent corrections - driven by a broad-based boom. While large caps are gaining, mid- and small-caps are rising even faster, with hints of froth and a spreading equity culture,” RBI said in its March bulletin.

The market seems to have taken the stern warnings from the market watchdog in its stride. Though there was an immediate correction after the SEBI Chairperson’s strong words, small-cap stocks have roared back. The Nifty Smallcap 250, which corrected 10.7% within three sessions of the SEBI warning on March 11, has since gained 19.1%.

“The regulatory actions against small-cap stocks are testimony to the valuation froth in India,” Bloomberg quoted Bloomberg Intelligence Strategist Nitin Chanduka as saying.

The writing has been on the wall for some time. There have been enough indications that the regulator was uncomfortable with the sharp rise in small and mid-cap stocks. Earlier this year, the SEBI had directed the Association of Mutual Funds in India to ask its members to disclose results of stress tests on small-cap and mid-cap funds, showing the number of days they will need to liquidate the portfolio under stress conditions. SEBI had also asked mutual funds to discourage lump sum investments in small-cap and mid-cap funds, forcing many mutual funds to put restrictions on lump sum investments in small-cap schemes.

Part of the reason for the spectacular rise in small-cap stocks is the sharp rise in fund inflows into small-cap mutual funds. In 2023-24, small-cap funds saw record net inflows of Rs 401.89 billion, up 81.8% year-on-year. In comparison, the net inflows into mid-cap funds were Rs 222.26 billion, up 10% year-on-year, while large-cap funds witnessed a net outflow of Rs 6.13 billion. To put it in perspective, the negative inflows into large-cap funds in 2023-24 were despite Nifty 50 rising 28.6% during the year.

The buying spree had a disproportionate impact on the prices of small-cap companies since their floating shares are much lower than large-cap and mid-cap companies. SEBI defines small-cap shares as those with a market capitalization of less than Rs 50 billion and mid-cap stocks as those with a market valuation between Rs 50 billion and Rs 200 billion.

Small-cap stocks tend to perform well compared to mid-cap and large-cap stocks during times of economic prosperity and boom and vice versa. Stock markets have been doing well since the beginning of 2023-24, with retail investors investing heavily in markets. However, most of these inflows seem to have gone into small-cap and mid-cap stocks. The reason is simple: these companies are relatively new or are in the early stages of development, and the potential for growth is much higher than their large-cap peers. But it also means that these investments are into stocks that are much more risky and volatile.

The growth in most small stock companies has not been commensurate with the rise in their valuations. Prevailing high-interest rates have increased the cost of investments for many of these companies. Many of them have slowed down their capital expenditures. Also, the global economic slowdown has slowed the demand for exports from many Indian small-cap companies. Geopolitical tensions are also high with the Russia-Ukraine conflict and Israel-Palestine conflict showing no signs of easing.

As of April 29, the stocks making up the Nifty Smallcap 250 were trading at an average Price-to-Earnings ratio of 29.1 and average Price-to-Book ratio of 4.07.
 

Given the high valuations at which many small-cap stocks are trading, a correction in this space is  likely in the foreseeable future. Many small-cap stocks are likely to come under selling pressure and may see a decline in their prices in the near term. The returns are higher, but so are risks.