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Should You Invest in Small and Mid-Cap Mutual Funds and Stocks Now?

The Indian financial landscape has come under a cloud of uncertainty, with latest directives from the Securities and Exchange Board of India (SEBI) mandating mutual fund houses to disclose their stress-test levels. This move, aimed at evaluating the liquidity of funds, especially in the small and mid-cap segments, has injected a dose of fear and indecision among retail investors and traders. Compounded by the volatility expected from the upcoming Lok Sabha elections, the market's stability seems to be on shaky ground. However, understanding the dynamics of these developments is crucial for savvy investing during such turbulent times. And that is why it is crucial that investors like you should understand the impact of these reports on your current portfolio and plan ahead to minimise the risk. In today’s blog, we shall discuss the latest ‘stress-test’ mandate by SEBI, its essentiality and the ‘dos’ and ‘donts’ during this time.

What is a stress test?

First and foremost, let’s decode this term – ‘stress-test’. In technical terms - SEBI is in the process of evaluating the time that the AMCs would require to liquidate their funds in small and midcap companies, in the event of a market crisis and subsequent increase in the number of investors redeeming their investments. Now, in simple terms, this means – SEBI is taking a cue from the mutual fund houses to understand how quickly the fund houses sell small and midcap stocks if many investors raise a request to redeem their units. While this is just a part of the stress test, the other part is to consider the impact of the selling on the small and midcap stocks. As you may know – heavy selling leads to price depreciation, which leads to consolidation which is followed by more panic selling. SEBI through its stress test is trying to understand how the sell-offs in the small and midcap company stocks will directly impact their stock prices and what would be a convenient way to prevent panic in the market.

Why (and why now) is the SEBI so concerned about the rally in small and midcap stocks?

This one is perhaps the most frequently asked question in the minds of traders and investors. Why is SEBI suddenly becoming cautious of the rally in mid and small-cap companies now? Isn’t it late? Well, according to SEBI – it is concerned over the heightened valuations of the mid and small-cap companies. Valuation is dependent on many factors, but one of the most important factors to consider is the investors’ stake. SEBI’s spotlight directly hit on these indices because of the growing stake that fund houses hold in these stocks. According to reports, fund houses in India increased their stake in small-cap stocks by nearly 107% to 41,000 crores in 2023 against 19,795 crores in 2022! Not only this, AMCs also favoured mid-cap stocks staking up a 12% increase on an annual basis from Rs 20,550 crore in 2022 to Rs 23,000 crores in 2023. While the benchmark indices have faired well, mid and small-cap indices have enjoyed a strong bull run starting from the COVID-19 period.

To speak figuratively, the Nifty50 index jumped from 19,435 to 21,731 from September 2023 to December 2023, an increase of 12% every quarter. However, this is not the case with the small and midcap indices. Nifty Smallcap 100 surged almost 22% to grow from 12,386 to 15,143 and the Nifty Mid-cap Select grew 16% from 8,926 to 10,398 during the same period. These numbers display the interest of investors. More than the interest, it displays that the number of participants in the small and midcap companies is higher than that involved with benchmark indices. The higher the participation, the higher the volatility, the higher the risk.

Now come to the most important factor – valuations. In recent times, SEBI evaluated that the prices of small and mid-cap company stocks are higher than large-cap companies. Don’t think of this in actual terms, but think of this in terms of valuations. For example – a share of ITC Ltd (Large cap) is trading at 417 at a P/E of 25, whereas a share of NTC Industries Ltd is trading at 113 at a P/E of 28.7. This means the stock of a small-cap company is valued higher than that of a large-cap company. It is to be considered that ITC Ltd has continuously paid dividends and is almost debt-free. Whereas, NTC Ltd has not announced any dividends to date and has a net sales of only Rs 49.42 crores against ITC’s Rs 70,919 crores annually. Now, this is a serious concern. While this doesn’t mean that NTC isn’t a company to invest in, what it means is that the price of a share of this stock is quite higher than it actually should be.

So, why is the SEBI concerned now? Why did it not act before?

Because it knows how the markets will react. SEBI knows how to tackle the market conditions. While certain things are still under wrap, it is surely working with the Association of Mutual Funds (AMFI) and other bodies to control the panic.

What should investors do now?

Always remember – investing is a long-term game. It does not start today and end tomorrow. So patience is a must. Other than this, what investors could do is better take this opportunity to scout some exciting and cheaper opportunities in large-cap stocks and start building a dynamic portfolio. If you hold stocks of small and mid-cap companies, don’t just panic and square off your positions. Look back at these stocks. Take assistance from experts to understand their long-term targets and immediate stop-losses. Studying fundamental aspects of the company will provide you a better interpretation of the stock's sustainability. Another way of looking at this situation is to be opportunistic. Start monitoring small and midcap stocks which you think may have a better chance of holding their current prices and even providing favourable returns. At Motilal Oswal, we house more than 1,100 advisors at our investors' disposal who help investors not only invest but also understand investing. It is our philosophy of ‘knowledge first’ that sets us apart. Get your portfolio reviewed by our experts today.