Mid and small cap shares show promising signs of recovery

After struggling over the last one year, midcap and smallcap stocks are showing signs of renewed strength on hopes of demand and earnings growth following a rate pause by the Reserve Bank of India, among other factors.

The BSE Midcap and SmallCap indices have been rising for 11 out of 12 sessions, with the former rising by 4.3 percent and the latter gaining 5.3 percent in April. These gains mark the first month of positive performance after four months of losses.

The BSE Midcap and SmallCap had both suffered losses of around 7.4 percent and 9.3 percent, respectively, between the beginning of this year and the end of March. In 2022, while SmallCap rose by just 1.4 percent, Midcap saw a decline of nearly 1.1 percent.

Why the rise?

Analysts have identified several factors behind the recent outperformance of midcap and smallcap stocks. These include anticipated demand growth, attractive valuations, and expected improvements in earnings, all of which have coincided with moderation in commodity prices. Moreover, positive macroeconomic developments, such as decreasing inflation figures and the RBI raising growth forecast from 6.4 percent to 6.5 percent have bolstered the market sentiment. Additionally, the decision to pause interest rate hikes has been welcomed by market participants while the shift of foreign institutional investors (FIIs) from net selling to net buying has added to the positive momentum in the market.

Sneha Poddar, AVP, Research Analyst, Broking & Distribution, MOFSL, suggests that the surprising pause in rate hikes by the RBI in its April policy meeting indicates a minimal probability of any further hikes, and there may even be a rate cut from late CY23. “This implies that interest rate hikes are unlikely to have a dampening effect on the markets. Moreover, any impact of previous rate hikes on quarterly earnings is expected to be offset by the cool-off in commodity prices. Therefore, it may be advisable to accumulate selective quality names in the broader markets, particularly small caps, where signs of earning visibility are improving,” she said.

Attractive valuations

Analysts say the recent substantial decline of around 15 percent in smallcap stocks during FY23, compared to negligible gains made by the Nifty and Midcap indices, has made valuations attractive for many smallcap stocks. Despite concerns surrounding weak macroeconomic conditions, high inflation, and rising interest rates globally, these valuations are expected to get investors interested.

The BSE midcap index is currently trading at 22.5 times one-year forward earnings, which is lower than its five-year average of 24.61 times, according to Bloomberg data. Similarly, the BSE smallcap index is trading at 18 times one-year forward earnings, which is below its five-year average of 22 times.

Raj Vyas, Portfolio Manager at Teji Mandi, anticipates that the stability of crude oil prices will help keep inflation within the RBI’s comfort levels and support credit offtake and macroeconomic demand. “As a result, margin improvements are expected across various sectors, including Auto, FMCG, cement, Manufacturing, Chemicals and others. In the longer term, themes such as infrastructure and capital goods are likely to remain relevant while banks are expected to outperform other sectors in the medium term,” he said.

Since the start of April, in midcap, Godrej Properties gained 28 percent, IDBI Bank, Macrotech Developers and AU Small Finance Bank jumped 21 percent each while GMR Airports Infrastructure and Mahindra and Mahindra Financial Services Ltd climbed 18 percent each.

Among smallcaps, Vinyl Chemicals India jumped 72 percent, Tanfac Industries advanced 65 percent while Precision Camshafts, Bombay Dyeing and Manufacturing Co and DB Realty surged over 55 percent each. Pokarna, Black Box and Dhani Services rose 52 percent each.

Gaurav Dua, Senior VP and Head of Capital Market Strategy at Sharekhan by BNP Paribas, suggests that the correction in mid and smallcap stocks may offer better prospects in the coming years. Nevertheless, he cautions that it is difficult to predict the exact bottom or start of a new rally. As a result, he advises investors to cautiously invest in high-quality companies over the next few months.