The correction in mid- and small-cap stocks, which began in January 2017, appears to be gathering momentum now. The Nifty Midcap 100 is down 10.6 per cent year-to-date (YTD) and 13.5 per cent compared to its 52-week peak. The corresponding numbers for the Nifty Smallcap Index are 14.1 per cent and 19.1 per cent respectively. New investors in particular, who entered the markets during the recent rally and have never experienced a correction, need to hold on to their equity investments.
Valuation discomfort: Discomfort with over valuation in the mid- and small-cap space is primarily responsible for the ongoing correction. On January 12, the Nifty Midcap 100 was trading at a trailing price-to-earnings (PE) ratio of 54, while the Nifty Smallcap 100 had touched a PE of 113.31 on January 15. “Between October 2013 and December 2017, the mid-cap index moved up around 175 per cent and the small-cap index moved up about 205 per cent, while the Sensex moved up only 55 per cent. As a result, a valuation gap had developed which couldn't have sustained indefinitely,” says S. Krishnakumar, CIO-equities, Sundaram Mutual Fund. He adds that a large part of the return had come from PE expansion, and earnings growth, while better in the mid- and small-cap space (than in the large-cap space), failed to keep pace with price rise.
Recategorisation has sparked a sell-off:
Many equity fund categories, like large-cap funds, had allocations of almost 30-35 per cent to mid- and small-cap stocks. Since April fund managers have been rejigging their portfolios. Experts estimate that almost Rs 750-1,000 billion worth of mid- and small-cap stocks will have to be sold. Th exercise will end by June.
Macro-economic woes: With the general elections coming up next year, the market fears that the government may put reforms on the back burner. India's macro-economic woes have also mounted. “With the macro-economic environment turning adverse, the euphoria in the mid- and small-cap space has vanished and valuations are reverting to mean,” says Tejas Khoday, co-founder and CEO, Fyers Securities. Adds Ankur Kapur, founder, Ankur Kapur Advisory: “Rising crude prices will contribute to higher current account deficit, and push inflation higher. Interest rates are already on the upswing. When companies' cost of capital goes up, their margins, and hence earnings, are adversely affected.”
Evaluate fundamentals of holdings: Most seasoned investors would have booked profits in their mid- and small-cap holdings as valuations touched irrational levels last year. Now, they should review their portfolios constantly. “If you had done your homework at the time of purchasing stocks and are confident about their business model and management quality, hold on to them,” says Jatin Khemani, founder and chief executive officer, Stalwart Advisors, a Sebi-registered independent equity research firm. On the other hand, if you had picked a stock just because it was rallying on momentum, and now find that it is fundamentally weak, get rid of it. “With the trailing PE for the Nifty Midcap 100 and Nifty Smallcap 100 at 48 and 51 respectively, these stocks may correct more. Fundamentally weak stocks will get beaten down further,” says Kapur.
For more than a couple of years now, investors have been lamenting the lack of buying opportunities. This correction, if it continues, will throw them up again. “Last year, when valuations had risen very high, you should have parked fresh money in liquid funds or short-term debt funds. Now that valuations are correcting, start looking out for opportunities,” says Kapur. Adds Bengaluru-based S G Rajasekharan, who teaches Wealth Management at Christ University and is an avid equity investor: “Keep evaluating stocks and develop a list of those you find to be fundamentally attractive. Then calculate the price you are willing to pay for them. As the correction brings stocks within your estimated price range, buy them.”
Khoday suggests putting fresh money in large-cap stocks. “Many opportunities are available in the large-cap space, in themes like rural consumption. Many large-cap stocks having low debt-to-equity ratios are available. These are the stocks to be in. High valuation stocks will correct deeply, barring consumption-oriented (FMCG) stocks, where a valuation of above 40 may sustain.”
However, don't lose faith in the mid- and small-cap category altogether. “Earnings growth for the stocks we hold in our mid-cap and small-cap funds will be above 30 per cent over the next one year, compared to 11-15 per cent for large-cap stocks in our funds,” says Krishnakumar. He adds that this space can reward investors having a five-year horizon.
Diversify by asset and geography: Mid- and small-cap mutual funds have held up reasonably well so far. Of the 38 unique funds in this category, only 10 have declined more than their benchmarks.
Investors who follow an asset allocation based investment approach would have 30-40 per cent of their equity portfolio in mid- and small-cap funds. They should ideally have booked profits in this space during their annual portfolio review last year. Those who failed to do so will witness sharper value erosion in their portfolios. Investors whose systematic investment plans (SIPs) are linked to long-term goals should continue with them.
Those who entered the markets recently, and have a single equity-fund in their portfolio, should diversify by putting new money in fixed-income instruments, short-term debt funds and gold, thereby bringing their equity allocation down from 100 per cent to 60-70 per cent, depending on their risk appetite. Those who have been in the markets for a while should diversify by adding international funds (make diversified international funds or US-based funds your first pick). This will make their portfolios less susceptible to India-specific risks.