Is there froth in the Mid-Cap and Small-Cap segments?

Today, the Indian stock market witnessed a rollercoaster ride as most indices ended the day in the red. Despite some attempts at bargain hunting in key benchmark indices, small-cap stocks and mid-cap stocks bore the brunt of heavy selling pressure.

The Sensex, initially showing promise with a higher opening, quickly reversed its gains, hitting an intraday low of 72,515.71 before closing at 72,761.89, down by a significant 906.07 points or 1.23%. Following suit, the Nifty 50 also succumbed to downward pressure, touching an intraday low of 21,905.65 and closing at 21,997.70, down by 338 points or 1.51%. Meanwhile, the broader market continued its downward spiral for the third consecutive day, with the BSE MidCap plummeting by 4.20% and the BSE SmallCap index taking a hit of 5.11%.

Experts attribute this downward trend in mid-cap and small-cap indices to SEBI's concerns regarding froth building up in these segments. This prompted the Association of Mutual Funds in India (AMFI) to direct mutual funds to undergo stress tests every 15 days, starting March 15, to evaluate their resilience in weak market conditions.

“In the context of froth building up in the small and mid-cap segments of the market and the continuing flows in the small and mid-cap schemes of mutual funds, trustees, in consultation with the Unitholder Protection Committee of the AMCs, shall ensure that a policy is put in place to protect the interest of all investors,” AMFI said.

Sandeep Pandey, Founder at Basav Capital said, "Current volatility in the Indian stock market, especially in small-cap and mid-cap segment, can be attributed to the market regulator SEBI's concern raised over the froth building up in the small-cap and the mid-cap segment. This prompted the mutual funds body AMFI to ask AMCs (asset management companies) to go for stress tests and asses the time taken to exit the position when the market mood is bearish. The AMFI's directive is one of the reasons for churning in the Mutual Funds PMS. Now, fund houses that don't even take cash calls but had high exposure in mid-caps and small-caps, have churned their portfolio and have moved to large-caps with quality names."

Securities and Exchange Board of India (SEBI) has raised red flags about possible price manipulation in initial public offerings (IPOs) and trading of shares belonging to small and medium enterprises (SMEs). 

The Association of Mutual Funds of India (AMFI), representing mutual funds, has also urged fund managers to take proactive steps to protect investors' interests.

SEBI Chairperson Madhabi Puri Buch acknowledges the presence of certain signs indicating price manipulation in SME IPOs and trading but clarifies that immediate action cannot be taken due to regulatory requirements. Market participants and analysts have also pointed out instances of rigging in the IPO process and manipulation in prices post-listing.

“In terms of actual price manipulation (in the SME segment) both at the IPO level and the trading level, we are working to evidence that, and we do see the signs. We have the technology to do it, so we are able to see certain patterns. However, as per the regulations, the way we need to construct the entire case, we do need to take some time to do that in a robust manner,”Madhabi Puri Buch said at an AMFI event.

SMEs are increasingly opting to go public to raise funds, with a significant surge observed in the number of SME IPOs. In 2023 alone, there were 182 SME IPOs, collectively raising over Rs 4,600 crore, marking a substantial increase compared to previous years. The National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) have established dedicated SME listing and trading platforms to facilitate this trend.

However, the surge in investor interest in small-cap and mid-cap stocks has raised concerns among regulators. Over the past year, these segments have witnessed significant inflows, driving stock prices up by 100-200%. This surge has prompted regulatory bodies to urge moderation in the flow of funds into small-cap stocks to prevent potential bubbles from forming.

In response, AMFI has advised asset management companies (AMCs) and fund managers to implement measures such as moderating inflows and rebalancing portfolios to safeguard investors' interests. SEBI has echoed these sentiments, emphasizing the need for trustees to formulate policies to protect investors from potential adverse impacts resulting from market bubbles.

Analysts have also raised concerns about overvaluation in the small-cap segment, citing indicators such as the price-to-book (PB) value ratio of the BSE small cap index. A PB ratio of 3.36 suggests overvaluation, prompting caution among investors. Amit Goel, Co-Founder and Chief Global Strategist at Pace 360, warns of potential market derating if actual economic performance falls short of optimistic projections.

Another analyst highlights the possibility of a significant market correction, with downside potential ranging from 30-40%. Investors are advised to exercise caution and refrain from being swayed by irrational exuberance in the market. V K Vijayakumar, Chief Investment Strategist at Geojit Financial Services, advises investors to stay away from overvalued small and mid-cap stocks, emphasizing the importance of prudent investment decisions amidst market uncertainties.

In conclusion, while the Indian stock market presents lucrative opportunities, investors must remain vigilant and exercise caution amid rising concerns about potential market bubbles and overvaluation. By staying informed and making prudent investment choices, investors can mitigate risks and navigate the turbulent waters of the stock market with greater confidence.