Meaningful Minutes

The rally:

The BSE midcap index is up around 30% since the start of 2017. The benchmark index for smallcap stocks too rose around 26%. In contrast, the market benchmark Sensex made steady gains over the period. It’s now up 10% year-to-date. The rally in the midcap and smallcap space started in February last year. And it has been rising steadily. In fact, the midcaps outperformed the Sensex for the past three straight years. Experts now wonder if there’s a bubble in the making in the midcap and smallcap space.

Not a ‘foreign’ phenomenon:

Foreign institutional investors (FIIs) are one of the largest movers and shakers in the Indian stock market. A rally can often be attributed to FIIs investing in large numbers. However, in the last one year it was domestic investors who drove the market. Domestic investors (DIIs) invested over Rs 56,500 crore in Indian equities in FY2016-17. In contrast, FIIs invested only Rs 55,700 crore, as per a Bloomberg report. In fact, FIIs have been net sellers except for the month of March 2017. DIIs, meanwhile, have been net buyers. This shows that the rally in midcap, smallcap stocks has been driven by Indian investors.

Premium prices:

Irrespective of who invested, what matters is if the high price is justified. For this, we compare the stock price with the company’s profit per share. This is called the Price-to-Earnings (PE) ration. It shows how much you pay for every single rupee of profit made by the company. During bull markets, midcap and smallcap investors traditionally pay high premiums than large-cap investors. They usually pay around Rs 25.5 for every rupee of profit earned by the smaller companies, as per the Bloomberg report. This is higher than the Rs 20 that large cap investors pay. At the current high rates, however, investors are paying as much as Rs 30 for every rupee. This is the worrisome part. This indicates that while stock prices are rising, companies have not reported a significant improvement in business to justify the high prices. This makes such investments riskier.

Limited knowledge of brands:

A Kotak Securities report pointed out that some of the stocks with high valuations are those of semi-branded companies. These are names that aren’t that well-known. “It is also possible that limited knowledge about the ‘undiscovered’ names may have made it easier for a section of the market to believe narratives about the names,” the Kotak Securities report said. This means that the investments in such stocks may not be well-researched. This increases the chance that investors could suddenly feel the investment was not worth it. This could lead to a sudden crash.

Faith in earnings recovery:

Another reason for the rise in midcap, smallcap stocks is that investors believe earnings are likely to pick up. So they could be investing today in anticipation of future profits. This can be seen in the high PE ratio. In fact, data shows that smaller the company, higher the PE. Companies with a market cap of less than $1 billion have a PE of 41.8, as per the Kotak report. This falls to 26.1 for companies with a market cap between $1 billion and $2.5 billion. However, it remains to be seen if the earnings will actually pick up as expected. If it doesn’t, investors could lose patience. The prices could then come crashing.

How to pick good midcaps:

All said and done, there could be some midcap and smallcap stocks worth the investment. However, it’s important that as a long-term investor, you look at the company’s profit-making abilities—the fundamentals. Look hard at its ability to make profits in the future. See if the business can withstand any new competitors in the market. This is especially crucial in today’s world when technology makes it easier to start a new business.