In recent months, the mid-cap and small-cap segments have seen a sharp rise, outperforming the blue-chip benchmark indices. However, according to Kotak Institutional Equities, trying to find solid fundamental reasons for this phenomenon is a challenging task. In fact, many companies in these segments saw their fundamentals worsen, which led to investors wondering what the driving force behind the current rally is. According to KIE, irrational exuberance seems to be leading the markets, where investors chase high returns based on recent performance, rather than sound fundamentals.
Kotak Institutional Equities pointed out that this exuberance wasn’t uniform across the mid-cap and small-cap universe. Several factors contributed to this market sentiment. The rapid price increase in these stocks, substantial inflows into mid-cap and small-cap mutual funds, and a surge in retail participation in these segments all contributed to this exuberance. The stellar performance of mid-cap and small-cap indices had further fueled return expectations among retail investors.
On the other hands, new favorites in sectors like capital goods, defense, EMS, railways, real estate, and renewables delivered impressive returns. However, these stocks had mediocre historical execution and governance track records. Additionally, many of these sectors operated in the B2G or B2B categories, posing execution and profitability challenges. Market expectations for revenues and profitability in these sectors might have been overly optimistic.
Some mid-and-small-cap stocks fell into the category of “turnaround” stories. These companies had faced severe operational and financial challenges, including bankruptcy, in recent years. However, the market seemed optimistic about their future prospects, leaving experts, including Kotak Institutional Equities, puzzled about the basis of this confidence.
Reassessing midcap portfolios
In light of these trends, Kotak Institutional Equities dropped its recommended mid-cap portfolio. Beyond the BFSI (Banking, Financial Services, and Insurance) space, finding stocks with substantial potential upside to their 12-month Fair Value had become increasingly challenging, said the brokerage. Many non-BFSI stocks had traded at or above their 12-month Fair Values. This shift resulted from soaring stock prices, reflecting what Kotak Institutional Equities believed to be the irrational exuberance prevailing in the mid-cap and small-cap segments of the market.