InvestorQ : What is the reason that mid cap and small cap stocks are underperforming the market since the beginning of 2018 and how do you see this changing in the future?
Aditi Sharma made post

What is the reason that mid cap and small cap stocks are underperforming the market since the beginning of 2018 and how do you see this changing in the future?

Aashna Tripathi answered.
2 years ago

From the lows of 2018, the Nifty is already up more than 20%. During the same period, the Nifty Mid Cap Index is down by over 15% while the small cap index is down by over 20%. Let us first look back and try to understand the reasons why these stocks have underperformed the Nifty in the first place. Broadly, there are 4 reasons for the underperformance of the mid caps and small caps since early 2018.

Oil gains are not what it used to be between 2014-2017

If you look at mid caps and small caps in the last 3 years, they were stark outperformers till the end of 2017. One of the major factors that worked in their favour was the price of crude oil. When crude oil falls, the dividends of cheap oil in the form of lower inflation and lower cost of inputs is enjoyed the most by these smaller companies. When oil started to rally from the $40/bbl level, few expected the oil rally to be prolonged. However, since the beginning of the year, the prices of crude have rallied by more than 40%. This has reversed most of the benefits of cheap oil that mid caps and small caps had enjoyed over the last 3 years. With the oil benefits gradually fading, the valuation premiums of mid caps came sharply into focus. That is what has been actually responsible for the underperformance of smaller stocks. This situation is unlikely to change unless oil begins a downtrend. With OPEC managing supply much better and the Iran sanctions kicking in from November, oil prices are likely to stay at elevated levels.

Budget 2018 spoilt the show with LTCG tax

The Union Budget 2018 imposed a tax of 10% on long term capital gains above the level of Rs.1 lakh during the year. However, there was a window for investors to book their long term gains before March 31st and cash out. A lot of institutions and HNI investors opted for this route as most of them had made healthy returns on mid-cap stocks. This had led to a spate of selling in these mid caps and most of these stocks never recovered from these levels. While, this was a temporary phase, the higher oil prices did not really give an incentive to these investors to enter these mid cap stocks again.

Additional Special Margins only soured the game

This was one of the principal reasons why the mid cap and small cap stocks corrected so sharply during the year. Seeing a huge froth built up in mid cap and small cap stocks, SEBI decided to go ahead and impose Additional Special Margins (ASM) on most of these stocks. This had two immediate effects. Firstly, the speculation on these stocks came down sharply and as the traders vanished, the prices started to fall sharply in the absence of support. Secondly, as the prices fell, the promoters and the HNI investors who had pledged these stocks had to either bring in more margins or to cut their positions. Most of them opted to cut their positions. This largely explains why the stocks fell so vertically in the last few months. These ASM margins are still continuing and SEBI is unlikely to withdraw these margins in a hurry. SEBI wants to avoid any risk of froth in these smaller stocks after similar experience in 2005 and 2006. This is likely to continue to weigh on the mid cap and small cap stocks.

Did you know that mutual fund stratification also played a role?

Lastly, the regulator issued new norms of classification for mutual fund schemes in the early part of the year. The reclassification meant that most mutual funds were using it as an opportunity to reduce their exposure to the small cap and the mid cap stocks. Also many small cap and mid cap funds had already stopped fresh inflows into their small cap and mid cap funds and that also relatively shut the taps of inflow into these funds. This reduced participation of mutual funds may stay for some more time till valuations are again back to attractive levels.

It is hard to say what holds for the future. However, the pain has been continued for long enough. There are some green shoots of recovery visible at this point of time. For now, the smaller stocks may remain under pressure. However, as valuations become more attractive vis-à-vis the large cap stocks, we may see the value diggers get back into these stocks. Good times for small stocks may not like before. Going ahead, the wheat will get separated from the chaff and only the solid mid caps and small caps will see good performance provided they are also backed by good corporate governance practices.