Can small-cap funds continue to show resilience? Many have warned of sharper drawdowns in this segment in the event of a market correction. The market correction has arrived, but it has not played out as expected. On the contrary, large-caps have taken a sharper beating. So have small-caps suddenly turned resilient?
Amid a broader market downturn in recent months, small-caps have shown surprising strength. Since 26 September, large- and mid-cap indices have tanked by 7.3% and 6%. The small-cap gauge, on the other hand, has only shed 2.7%. This performance runs contrary to usual expectations of sharper drawdowns in small-caps when market conditions turn sour. So have small-caps suddenly turned resilient? Or is this the calm before the eventual storm?#sr_widget.onDemand p, #stock_pro.onDemand p{font-size: 14px;line-height: 1.28;} .onDemand .live_stock{left:17px;padding:1px 3px 1px 5px;font-size:12px;font-weight:600;line-height:18px;top:9px} #sr_widget.onDemand .sr_desc{margin:0 auto 0;} #sr_widget.onDemand .sr_desc{color: #024d99;margin-top:10px;} #sr_widget.onDemand .crypto .live_stock .lb-icon{8px 6px 5px 3px !important} #sr_widget.crypto.onDemand a.text{border-bottom:1px solid #ccc;padding-bottom:5px;display:block;width:100%} #sr_widget.onDemand .sr_desc .text p, #stock_pro.onDemand .sr_desc .text p{font-size:12px;font-weight:400;} Over the past few years, the smallcap basket has enjoyed a stellar run. The Nifty Smallcap 250 index has soared 49.5% and 90% respectively, over the past 1 and 3 years. After this sharp uptick, experts have been sounding the alarm of overheating in this space. Many have warned of sharper drawdowns in this segment in the event of a market correction. The market correction has arrived, but it has not played out as expected. On the contrary, large-caps have taken a sharper beating. Yash Sedani, Assistant Vice President, Investment Strategy at 1 Finance, observes, “Small-cap stocks are regarded as the most volatile market segment, with mid- and large-cap stocks following in terms of risk. However, an interesting shift occurred in 2024.”
There are various reasons for this. First, foreign institutional investors (FII) have sold heavily during this period. They pulled out Rs 1.14 lakh crore in October. As it turns out, FIIs are mostly invested in the frontline stocks. Their stake in small-cap stocks is comparatively modest. So the heavy selling by FIIs has predominantly hurt large-caps and a few mid-caps. Ownership of the free float in smallcap stocks mostly rests with domestic institutional investors (DII), particularly mutual funds, where retail investors continue to pour money. This has kept small-caps from keeling over, for now. “Earlier, retail investors used to pull out from small-caps at the slightest hint of turbulence. Nowadays, investors put in more money at such times,” remarks Rushabh Desai, Founder, Rupee with Rushabh Investment Services, suggesting that retail investors are propping up these stocks.
Choppy markets singe large-caps
Typically, small-caps experience sharper declines during market corrections.
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Second, the weakness in the economy has started reflecting in the corporate earnings. India Inc’s earnings show has been disappointing, resulting in earnings downgrades. The tepid earnings growth in frontline businesses has disappointed investors. Earnings of 34 Nifty companies that have declared financial results until 3 November have been flat on a year-on-year basis. BPCL, JSW Steel, Coal India, IndusInd Bank, Reliance Industries, and UltraTech Cement have put on a weak show. Motilal Oswal, in its interim earnings review, has indicated that overall Nifty EPS has seen a 7% downward revision in the last six months, reducing the expected 2024-25 earnings growth to just 5%, weakest since 2019-20. Only three Nifty companies saw earnings upgrade of more than 3% for 2024-25, whereas 10 witnessed downgrades of more than 3%. Meanwhile, the earnings downgrades have not been as bad in the small-cap space. Median profit growth for the 123 small-cap companies out of 250 that have reported earnings so far stands at a healthy 23% year-on-year. Nearly 83 of these companies have reported positive earnings growth. Among these, the median profit growth is an impressive 39%. Tejas Networks, Multi Commodity Exchange, Inox Wind, Aster DM Healthcare and Amber Enterprises, among others, have put on a blockbuster show. “On the earnings front, the overall earnings picture of the market looks a bit weak, but some companies in the small-cap segment are displaying strong earnings growth,” observes Desai. Sedani contends that the mid-cap space has suffered primarily as its recent surge was driven more by PE re-rating rather than earnings growth, unlike in small-caps. The PE ratio of the Nifty Smallcap 250 rose from 28x in January to 32x by October. In contrast, the PE ratio of the Nifty Midcap 150 increased from 27x to 44x during the same period.
However, experts warn this perceived resilience among small-cap stocks is likely to be short-lived. Investors should not interpret this transitory strength as newfound tenacity in this segment. Pankaj Tibrewal, Founder and CIO, IKIGAI Asset Manager, warns earnings downgrades and price corrections in small-caps will follow. “Operating leverage is quite high for many smaller businesses, which will show up in the earnings. Eventually stock prices of small-caps will catch up,” Tibrewal contends. He points out that very few analysts track small-cap stocks, which is why the earnings downgrades have not been as pronounced. The resilience exhibited so far is led by a smaller pool of 40-50 stocks within the entire basket. A much larger set of stocks have buckled under the weakness.
Experts warn that despite the recent correction from the highs, the broader markets are still trading at expensive valuations. The Nifty50 is trading at a 12-month trailing PE of 22.4 times, in-line with its long-period average. Meanwhile the Nifty Smallcap250 index trades at 32 times, significantly higher than the historical average. “The current correction is still not steep enough to provide comfort on valuations so maintaining some caution is still warranted,” says Desai.
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This story originally appeared on: India Times - Author:Faqs of Insurances