Midcaps: Fire and ice?

Mid and small caps hold potential for wealth generation over years, usually with inconsistent yields. Midcap markets have been on fire, with the Midcap 50 Index gaining 33% over the last one year.

For the country, by any count this year has been seminal - from the G20 consensus declaration to the Chandrayan 3, a marvel in inexpensive space exploration engineering technology and capping it off with Aditya-L1 mission to the sun. In line with skyrocketing national excitement, mid and small cap scrips have also been flying high providing much needed
celebrations after wild swings of pandemic years. Now the question on everyone’ mind is what next? Let’s explore what’s driving the midcap rally, what investors can expect going forward and some strategies for dealing with the mid/small cap segment and its inherent volatility.

First some background: Mid and small caps hold potential for wealth generation over years, usually with inconsistent yields. Midcap markets have been on fire, with the Midcap 50 Index gaining 33 per cent over the last one year. Historically speaking, such joy may be short lived - the longer-term Midcap story (2018 onwards) is one of wild swings, with Midcap 2020 losses of ~35 per cent and a whopping -46.1 per cent for the small caps! 

Is the rally sustainable? Consensus on Dalal Street is that the rally appears to be unreasonable euphoria with expectations based purely on the current calendar year’s performance ergo, such sentiment turning neutral or negative may have a disproportionate impact on mid/small Caps. 

Secondly, mixed signals: At the broader macro level, India manufacturing growth has been better than rest of major economies and investors with higher growth expectations invest, have been beneficiaries of  

1. GDP growth up (Q1FY24 is at 7.8% versus FY23 number at 7.2%), 

2. GST collections up by 11% and 

3. Output of eight core industries was strong at 8%. 

But there are headwinds: 

1. 2nd monthly sequential decline in output by -2.2% - is the tide turning or is this simply seasonal dip because of poor weather and inconsistent monsoon?  

2. Manufacturing PMI 5.7 in August v/s 5.8 in June and,

3. Softer credit offtake for industry and services (lower than expected loan disbursal) as consistently high interest rate impact beginning to show. 

Overall, this mixed bag may indicate a slightly slower momentum, but it isn’t likely to derail growth. And with the fiscal deficit rising along with persistent inflation, there remains some concern. 

How does this compare with large caps?

This contrasts with more stable headline indices. The 9% rise in the BSE Sensex in 2023  compares poorly with mid & small cap index returns previously mentioned. Investors in large cap and blue chips look for consistency in returns, and as volatility increases, some may be attracted by relatively calmer largecap space.  

The way forward:

As per August-end AMFI mutual fund data, 33% net equity inflow was into mid and small caps. Within equities, midcaps have traditionally been more volatile as the retail participation has been higher. Additionally, given somewhat tepid economic data, not all mid and small caps will continue to thrive. Navigating this high-risk, high-reward segment will now require a structured investment approach:  Implementing strategic allocation for the core portfolio and tactical allocation to exploit timely corrections or spikes. Consistently book profits so the allocation to the segment is rarely above target allocation and constant rebalancing may help prevent excess drawdowns. Further, there is nervousness on macro uncertainty and valuations hence a larger share to largecap segment may be appropriate, even attractive for now. 

Last but not the least, should an investor be not entirely comfortable taking decisions, they may wish to consider external advice or research, or management from SEBI registered intermediaries to assist with construction, midcap management, and strategic/tactical distribution.

(The writer is Managing Partner, Aryzen Capital Advisors)