The pressing question that is on the top of investors’ mind: Will the recent turmoil in small and midcaps, caused by increasing SEBI oversight and regulatory overhang, morph into a manic price correction in the broader space? Or will it be another transient stumble that will subside soon? First, a bit of context on the recent correction, before we dive deeper into those questions. When the year began, there were no signs of any stalling for the stellar run for small caps. The one way run that started in April’23, continued its bullish course well into mid-March until it hit the wall of SEBI strictures. The blow came in the form of stress test prescriptions from SEBI for the small and mid-cap mutual funds, besides the sudden coordinated actions from RBI-SEBI in stemming the flows into the primary markets. This coming on the top of an unusually strong comment from the regulator on the market level, calling it a froth in the small-cap space, set off a sharp slump in the small and midcap segment. This resulted in the small-cap index crashing by over 14% from the highs it touched in Feb, before making a marginal recovery in the subsequent trading sessions. The index is still down by 8%+ from the peak even after this recovery, reflecting the nervousness in the broader space.
Now, the key question that the investors are grappling with is, is this the beginning of another bear cycle in the small and mid-cap markets as happened in 2018? Investors are rightly worried as there is an eerie similarity to the 2018 downcycle. The small cap index was up by over 58%+ in 2017 when the sharp slide started in 2018. The situation is not far different now with the index up by over 47%+ in the previous year 2023. Valuation multiples are at a historical high across the market segments. But the similarities stop there. In 2018, the market was staring at the prospect of interest rate tightening cycle and was worried about the consequent macro risk events like the IL&FS crisis and balance sheet issues in the banking sector in general.
If one goes back and looks at all past downcycles, one will realize that in addition to expensive valuation, one needs other key ingredients either in the form of macro risk events or a hawkish interest rate environment for sharp price corrections in the broader space. One would find this common pattern across all the down cycles. Do we find such a pattern now? Yes, valuations are indeed expensive across the market segment compared to historical levels. Is that alone sufficient for a sharp price correction?
In the current context, two key ingredients that are critical for sharp price corrections are missing in that pattern. Global macro looks resilient with the recessionary risks in the developed world receding convincingly. With the Fed set for multiple interest rate cuts this year, interest rate outlook is far more benign now. In such a situation, sharp price correction looks more and more unlikely. Having said that, given the expensive multiples in which the broader space is trading, markets are likely to get into a consolidation phase with actions shifting to bottom-up stock-specific arena, as further upside at the index level may be limited. If one is on the right stock at the right price, it is still possible to eke out decent returns in this emerging scenario of range-bound markets in the small and mid-cap space as the markets are likely to reward stock specific actions.
There is another compelling reason why we believe that the markets will turn stock specific. It stems primarily from the nature of current economic expansion which is led by investments. The current cycle of expansion looks strikingly similar to the FY03-07 cycle that was propelled by private capex. In that cycle, the investment to GDP ratio rose from 27% in FY03 to 39% in FY08 which was close to peak. Investment to GDP then hovered around those levels until it peaked in FY2011. It suffered a decade of decline over the subsequent years to hit a low of 28% in FY2021. From that low, it has now bounced back to over 34% in FY24. As per the consensus estimates, this ratio is likely to move up to over 36% by FY27. This sharp rise in the investment ratio is likely to be the defining nature of the current expansion.
Currently the investments are led by public capex. As has been highlighted in many forums, Govt’s capex has moved from around 1.6% of GDP a few years back to 3.4% of GDP now (as per FY25 interim budget). Now, it is time for the baton to shift to private investments. With corporate profits as a percent of GDP moving from a trough of 1.1% FY2020 to 5.3% in FY23, it is a question of time before the corporates start loosening their purse strings for capex. Early signs are already there for everyone to see in terms of greenfield capacities being put up by India Inc in steel, cement, renewables, ports and airports. As the capex cycle extends, the impact will trickle down by lag effect to consumption that has been currently under pressure.
Overall, given this benign macro-outlook, this is not an easy market for investors who are waiting on the fence for sharp price correction. It doesn’t look like this will get any easier in the coming weeks and months. Yes, the recent correction in the small-mid cap space has taken some froth away from the valuations, but expecting sharper price correction may only lead to a major disappointment to investors. Of course, the disclaimer is, if there is a surprise in the upcoming election outcome, scenario could be significantly different for the markets’ direction. Assuming there is no surprise on that, investors may not have much choice but to look at SIPs or look at AIF or PMS funds which will invest in a phased and cautious manner using the cool-off, wobble or consolidation that is likely to be the nature of the current market direction, instead of waiting endlessly for a sharp price correction in the broader markets!
Happy Value Investing!
This article of mine was published in the online edition of Economic Times (01/04/2024). Glad to share the link: https://economictimes.indiatimes.com/markets/stocks/news/is-the-market-turning-stock-specific-in-broader-space-amid-growing-sebi-strictures/articleshow/108951780.cms?from=mdr
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