Smallcap, midcap stocks surge: CLSA urges caution amidst stretched valuations, remains selective

The Indian stock market indices Sensex and Nifty 50 witnessed a remarkable rally in the year 2023, with both the benchmarks gaining around 20% each. However, the real action unfolded in the broader markets where the midcap and smallcap indices outperformed the frontliners by a huge margin. The smallcap and midcap companies dominated headlines in 2023, surging by 44.6% and 49.1% over the year, respectively, marking one of the best annual performances for Smids.

The Nifty Smallcap 100 and the Nifty Midcap 100 indices scaled record highs this week. Most of the rally in smallcap and midcap space came from a few sectors that have a small presence in the large cap space, like real estate and power. “A closer look at the rally suggests that the enthusiasm for Smids may have been guided by a strong investor preference for sectors with a large proportion of stocks in the Smids category and a smaller presence in the large cap space," foreign brokerage CLSA said in a report.

Among the top 500 stocks, real estate, power and autos sectors have seen almost all stocks outperform their respective market cap benchmarks. On the other hand, chemicals, logistics, cement, telecoms, consumer staples, consumer durables and consumer discretionary have been notable underperformers, analysts at CLSA noted.

Given this robust performance, analysts express concerns about the stretched valuations of small cap and mid cap stocks. They believe that sustaining further outperformance may pose challenges. “The strong performance has taken the relative valuation of both mid caps and small caps versus the Nifty to well above one standard deviation of their long term average premiums, at a time when the Nifty is trading well over one standard deviation above its own historical average PE.

As valuations are clearly stretched, further significant outperformance may not be easy," CLSA said. The brokerage recommends being selective in this space. For financials, CSLA likes , Max Financial Services and Mahindra & Mahindra Financial Services. In the industrial sector, it prefers , NCC and .

“For consumption, we recommend investors play the long term export story through Dixon Technologies and Amber Enterprises as well as the evolving domestic consumption theme through Inox and RBA. We like and Mahanagar Gas in the energy sector. and Prestige Estates are our other top Smid Buy ideas," CLSA added.

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