Brokers: Brokers back small and mid-cap stocks on high earnings outlook

Mumbai: Notwithstanding heightened concerns over froth and over-valuation in the small-cap and mid-cap space, some money managers and brokers are recommending to investors with a high-risk appetite to make fresh investments in such stocks or schemes that invest here. Strength in earnings growth and decline in share valuations in the mid-cap and small-cap segments following the recent drop in stock prices are some key reasons for holding them or buying them afresh.

Motilal Oswal Asset Management said in a note that the valuation premium that mid-cap and small-cap indices held over Nifty has halved to 14% for both against 24% and 29%, respectively.

BSE SmallCap index has fallen 11.32% from its February high, while the mid-cap index has fallen 6.25%. Many small-cap and micro-cap stocks have dropped 20-45% on average in this period. Motilal Oswal AMC’s optimism on these stocks is on the grounds that earnings growth is still strong. “High earnings growth estimates, participation in market-favoured themes and dedicated investment flows make a continued case for investment into mid- and small-cap funds,” said the fund house, which recommends long-term investors with one to over five years investment horizon to invest in them. For FY23 to FY25, it estimates earnings growth for mid- and small-cap index at 31% and 33%, respectively as against 16% in large-caps.

The optimism is also because the hot investment themes such as manufacturing, capital goods and niche high-growth businesses in healthcare and IT are smaller companies. ICICI Securities said small-caps are at their most ‘unattractive relative valuation zone’ in terms of their risk premium over large-caps, although this has been mitigated in the recent correction.

“Empirical evidence indicates the trigger for bear markets within small-caps (>20% fall) has emanated from being in a high valuation zone, followed by a slump in economic growth and/or ‘monetary tightening cycle,’ both of which appear unlikely given the recent India GDP upgrades and benign interest rate outlook,” said the brokerage.

Anand Rathi Securities said its outlook for mid- and small-cap indices remains optimistic. “Despite a noticeable decrease in risk-free interest rate, which warrants higher equity multiples, we do not find froth in valuations,” said the brokerage. Fund managers warn the risks of more corrections in such stocks are high. “We observe pockets of irrational exuberance among mid- and small-caps,” said Trideep Bhattacharya, CIO, equities, Edelweiss Mutual Fund. “We anticipate that exercising mindfulness regarding valuations and being selective in stock-picking…will likely be crucial for outperformance in 2024.”