Is midcap, smallcap dream run coming to a close? Risk-reward no longer lucrative after mega rally

Amid the present bull run, midcap and smallcap indices have gone past their earlier benchmarks on multiple fronts. (Image: REUTERS)

Midcap and smallcap indices have been under the firm control of bulls since domestic markets started rallying last year. Outperforming the benchmark indices, midcap and smallcaps have narrowed the valuation gap to large caps significantly, but with this sharp rise, the risk-reward does not remain lucrative anymore, said brokerage and research firm Motilal Oswal. While the Nifty 50 index has soared 43% in the last one year, the Nifty Midcap 50 has galloped 73%. Similarly, the Nifty Smallcap 250 index has zoomed 107% in the last one year. 

Risk-reward not lucrative now

Amid the present bull run, midcap and smallcap indices have gone past their earlier benchmarks on multiple fronts. Mid caps and smallcaps have recorded consecutive months of positive returns, 12-month rolling returns gap against the Nifty has been better, relative valuations have jumped, and contribution to overall market capitalization is up. “The sharp outperformance of midcaps, bolstered by healthy earnings, improved sentiments, benign liquidity, and low cost of capital, has more than bridged the valuation gap against large caps,” they added.

Rising valuations have now eroded the discount to large caps, diminishing the risk-reward perspective. “Any risk-off owing to concerns over potential interest rate hikes may impact midcaps/smallcaps more in our view,” Motilal Oswal said. 

But dream run might not be over

Although valuations might be lofty, unlocking the economy could still work to benefit listed companies. “Balance sheets and cash flows have improved in financial year 2021 as corporates tightened costs and deleveraged. The gradual unlocking of the economy and an improved demand backdrop do offer bottom-up opportunities. Consistent earnings delivery v/s expectations is critical for further outperformance,” Motilal Oswal said.

The recent broad-based rally has led to a sharp increase in market cap contribution from the Midcap and Smallcap indices. The report highlighted that Midcap 100 index market cap now contributes 12.1% to the overall market cap, up from 9.8% in March last year. Meanwhile, Smallcap 100 companies’ market cap as a percentage of the overall market cap has increased to 3.7% currently, from 2.7% in March 2020. However, this is still below the 2017 peak market cap contribution by the midcaps and smallcaps.

Nifty smallcap 100 currently trades at a premium to Nifty 50 for the first time since 2014 and Midcap 100 valuations are trading on par with the benchmark index. “However, if one were to remove the loss-making companies from both the indices, then Nifty Mid-cap and Nifty Small-Cap indices are trading at trailing P/E of 21x and 23x FY21 earnings, at a marginal discount to Nifty,” the report said.