Why the rise of smids could draw further regulatory glare

Estimated read time 10 min read

Smid (small- and mid-cap) indices have recovered from their mid-March lows, after warnings of froth. The Nifty Midcap 150 hit a record 18,400 on Wednesday and the Nifty Smallcap 250 was just 2.8% shy of its 7 February record. Can this uptrend continue? Mint analyses.

How have smids performed ?

Broader market indices have outperformed large-caps, with the Nifty Smallcap 250 and Midcap 150 generating annualized returns of 21.36% and 22.2% over the past five years. This is significantly higher than Nifty’s annualized return of 13.93% over the same period. But the valuation picture is mixed. While the Nifty Midcap 150 traded at a price-to-earnings multiple (P-E) of 35.81 at end-FY24, above the historic 30.91 times median, the small-cap index traded at 26.38 times, below the historic 27.75x, thanks to recent regulatory advisories to mutual funds which resulted in small-cap stocks tumbling last month.

What has driven up the indices?

Relentless retail and HNI investor flows. Asset management companies’ (AMCs) small-cap funds attracted 73,718 crore and mid-cap funds 63,624 crore during FY20-FY24. Against this, MF large-cap funds garnered a modest 22,358 crore. This has driven up smid valuations. The increased flows are on the premise of future earnings growth. This is evident from earnings per share (EPS) five-year annualized growth of the small-cap, mid-cap indices at 18.6% and 19.29% each, lagging the Nifty EPS growth of 19.99%. Investors are betting that as India’s economy keeps growing at 7-8%, smids will outperform large-caps.

Can the smids uptrend continue?

Fund managers believe so, with the caveat that higher inflows into smids could draw regulatory glare again. Sebi told funds in February to run stress tests on smid portfolios to see how many days it would take them to redeem 25-50% of these in a downturn. The results in mid-March had no negative surprises. Funds will publish such stress tests by the 15th of each month.

What could regulatory measures look like?

AMCs could be directed to take a call on capping flows into their smid funds if they are unmanageable. Already seven AMCs, including Nippon India Smallcap Fund, Tata Smallcap Fund and SBI Smallcap Fund, have restricted investor flows into their small-cap funds. Some more of the 47 MFs could follow. This cautionary stance could itself result in pricking bubbles. Sebi recently asked MFs to disclose if they had sold retirement or small-cap funds with over three-year lock-ins to senior citizens.

What should retail investors do?

They should follow an asset allocation model, using systematic investment plan (SIP) if routing money through mutual funds or participate through SIPs offered by brokers if investing directly. Asset allocation involves putting money into multiple asset classes—equity, fixed income, debt, cash, gold, etc. By investing in multiple asset classes, investors can reduce risk, lower the probability of losses and improve the possibility of earning better returns, according to brokerage ICICI Direct.

 

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