Retail pain rises as smallcap stocks miss the bluechip party: Is the undercurrent turning bearish?

As the Sensex danced 1,300 points higher this week, toasting a 1.6% gain, the smallcap brigade looked like it had shown up at the wrong party — or worse, got turned away at the gates. The BSE Smallcap Index slipped 1.33%, and the real drama unfolded deeper down: at least 50 smallcap stocks crashed into double-digit losses, some nosediving as much as 18%.

Call it the tale of two markets. On one side, heavyweight Reliance Industries — India’s most valued stock — roared 9% higher, buoyed by a Q4 earnings glow and a fresh wave of FII love. On the other hand, investors in names like Gensol Engineering, Tejas Networks, Sterling and Wilson Renewable Energy, Godrej Agrovet, and Senco Gold lost money.

Foreign institutional investors (FIIs) pumped nearly $1 billion into Indian equities this week, drawn in by a softening dollar and the stability of bluechips. But while the giants soaked in the inflows, investors used the rally as an exit cue from broader markets that had sprinted ahead from April lows.

“By definition, the majority of the Indian market, except the top 250, is smallcaps,” said Dr. Vikas Gupta, CEO and Chief Investment Strategist at OmniScience Capital. “There are nearly 1250 smallcaps which are actually larger than Rs 1000 crore market cap, so they are actually quite large in size. This is where one will have to focus attention to build a wealth creating portfolio. We would caution against companies below Rs 1,000 crore market cap and penny stocks etc.”

Gupta warns against blindly chasing momentum. “Avoid the Capital Destroyers — high debt; Capital Eroders — low RoE; Capital Imploders — high PE stocks above 40; and companies with little to no growth. This isn’t treasure-hunting on WhatsApp forwards — it needs a scientific screener and real diligence.”

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Indeed, while some see the recent crash as a cleansing fire, others view it as a much-needed reset. “There has been a steep correction in many good quality mid and small-cap stocks. It’s a good time to add good-quality small and mid-cap companies that have favorable earnings growth ahead of them. The recent correction in the small and mid-cap space has provided an opportunity to pick up quality stocks at attractive valuations. They tend to outperform during periods of economic recovery, as they are more sensitive to growth in domestic consumption and infrastructure,” said Vaibhav Agrawal, CIO – Alternates (Public Equity) at Motilal Oswal AMC.

But the jury is still out on valuations.

“Mid and small cap valuations, though off the peak, are still trading more than one standard deviation above their historical average,” said Ashutosh Tiwari, MD and Head of Equities at Equirus Securities.

“Investors should look for companies that have a good track record on cash flow generation and trading at reasonable valuation vs their pre Covid multiples. In many cases investors look at the last 3–5-year average trading multiples and compare current multiples but it’s not the right approach as last 3-year multiples were significantly higher than the mean,” he said.

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Valuation red flags are flashing louder than ever. According to Nuvama, both the SMID (Small and Midcap) market cap-to-GDP and forward PE are hovering around levels seen in previous market peaks — 2007, 2010, and 2018. And what followed back then? Painful drawdowns ranging from 30% to 60%.

“While liquidity concerns have been largely addressed, growth concerns persist. SMID profit growth has been slowing as margin tailwinds have faded on a YoY basis. The falling crude could help somewhat, but that may not be sufficient to inflate earnings a la FY24,” Nuvama notes.

So is this the end of the road for smallcaps? Not quite. But it is no longer the high-speed highway of 2023. Investors need to unlearn the easy wins and embrace quality, discipline, and hard-nosed valuation sanity.

In other words, the smallcap rally may be down, but it’s not out.