‘Junk rally’ in Indian small-caps sparks fears of frothy valuations

Indian mid and small-cap stocks have soared in value over the past six months as retail investors and mutual funds snap up shares in previously-troubled companies, sparking concerns that some parts of the market have become too frothy.

The Nifty Midcap 50 index has rallied 39 per cent since late March — its lowest level over the past year — while broad gauges of smaller stocks are also making gains. The Nifty MidSmallcap 400 has risen 38 per cent over the same period. In contrast, the Nifty 50 index of India’s biggest listed companies is up just 15 per cent.

Retail investors betting directly on shares have partly driven the rally, which has lifted stocks that have previously suffered large losses as well as state-controlled firms, with WhatsApp groups publishing share tips becoming increasingly popular. Wealthy individuals and mutual funds have also been involved.

The buying spree has some echoes of the US’s meme stock frenzy of 2021, when retail investors rapidly drove up the price of shares of groups such as GameStop and AMC far beyond what many fund managers saw as their fundamental value.

“When we see there is such euphoria around, and especially names which have historically not delivered consistent returns, we don’t know how sustainable it is,” said Tej Shah, a portfolio manager at Mumbai-based Marcellus Investment Managers.

One of the best performing Indian stocks is Suzlon Energy, a wind turbine maker whose mammoth debt pile brought it close to bankruptcy in 2015 and is now in the midst of a turnaround. Its shares have rocketed 265 per cent in the past six months.

Another outperformer is majority state-owned train infrastructure builder Rail Vikas Nigam, whose shares have soared 126 per cent. Mazagon Dock Shipbuilders, a defence ministry enterprise 85 per cent owned by the government, is up 211 per cent in six months and the shares are trading at a price/earnings multiple of almost 38 times, compared with an average of nearly 23 times among stocks in the wider index.

“They are either turnaround stories or companies which have historically reported large amount of losses, or they are state-owned entities,” Shah said. The current top 15 to 20 gainers over the past 12 months in a wider benchmark of larger and smaller companies, the S&P BSE 500 index, “have historically delivered, in the past 10 years, returns which have either been next to nothing or negative”, he said.

One fund manager, who asked not to be named, described it as a “junk rally”.

“We see limited point in trying to find fundamental reasons behind the steep increase in stock prices of several mid-cap and small-cap stocks,” wrote Kotak Institutional Equities last month. “There is no meaningful change in the fundamentals of most companies; in fact, they have worsened in many cases.” The brokerage said it was dropping its mid-cap portfolio recommendations.

As the India bounces back from the coronavirus pandemic, optimism about the country’s growth prospects has partially fuelled the rise of small and mid-cap shares. The IMF projects India’s economic growth at 6.1 per cent this year, the fastest of any major economy.

While many retail investors are betting directly on small and mid-caps, R Venkataraman, chair of Mumbai-based brokerage IIFL Securities, said the main buyers were mutual funds, as well as wealthy individuals who are “seeing tremendous returns”.

Investors have ploughed Rs47.4bn ($570mn) into mutual funds investing in mid-cap stocks and Rs109.4bn into small-cap funds from April to June, the most recent quarterly figures available. In contrast, Rs33bn flowed out of large-cap portfolios during that period, according to data from the Association of Mutual Funds in India.

Venkataraman said the rally in small and mid-cap public sector banks, which have only very small free floats and whose prices can be influenced by relatively few trades, was comparable to the meme stock craze in the US.

But Vijay Chandok, managing director at financial services and broking firm ICICI Securities, dismissed any such comparison. “GameStop penny craze was a pure speculative event,” Chandok said. “We do not see any similarities” with Indian equities.

Some money managers say there is no cause for alarm, arguing there is a vast range of small- and mid-cap companies and that better earnings are largely driving price rises.

“Structurally a lot of the rally, at least in our stocks, has actually been driven by improved [financial] performance,” said Gaurav Narain, manager of the India Capital Growth Fund, a small and mid-cap fund, at Mumbai-based Ocean Dial Asset Management. He said his fund is up 27 per cent this year.

Moves by multinational companies to diversify supply chains away from China have “absolutely been a bonanza for a lot of these companies”, Narain said, adding that a bruising period for India’s economy prior to the pandemic had prompted many groups to clean up their balance sheets.

Trideep Bhattacharya, chief investment officer at Mumbai-based Edelweiss Asset Management, called Kotak’s mid-cap portfolio dumping “alarmist”.

But he conceded that “over the last couple of months we’ve seen pockets of irrational exuberance”. As a result, “we are now a little more selective in mid and small-caps”.