Small Cap and Mid-Cap stocks have been in the limelight for a little over 3 years now. But the one thing that we always remind investors is to stay grounded. The reason is simple and straightforward – Markets are cyclical in nature and have always been in the past. Take the classic case of the small and Mid-cap category which has witnessed significant growth and buying over the past 3 years. This buying spree in turn led to a lot of stocks within the segment becoming overvalued. Despite this, we have continued to buy, simply because of the upside that the two categories offered. But the buying story tipped and took a U-turn, after logging in all-time highs on February 8, 2024.

Despite the significantly high Price to earnings ratio of the small cap indices, they have continued to outperform, largely owing to their ability to generate higher Earnings per share. However, increasing cost pressures, largely led by the heightened demand for these stocks amongst other factors have led to a correction in these stocks over the recent period.

On February 27,2024, The Association of Mutual Funds in India (AMFI) wrote to the Asset Management Companies (AMC’s), announcing measures aimed at regulating investments in small-cap stocks. This move by SEBI, India’s market regulator, marks a proactive step to address concerns surrounding the ‘froth’ in the categories. volatility, liquidity, and investor protection in the small-cap segment. Let’s look at it in more detail:

Froth – What is it?

Markets are termed “frothy” when the probability of a future drawdown in prices is high. It refers to the presence of speculative excesses or inflated asset prices beyond their fundamental value. In the context of small and mid-cap stocks, frothiness can manifest in the form of rapid price escalation driven by speculative trading activity, without corresponding improvements in underlying business fundamentals.

Why is it Important?

Investing in small-cap stocks can pose challenges related to liquidity, as these stocks often have lower trading volumes and narrower investor bases. Illiquid markets can amplify price movements, making it difficult for investors to buy or sell shares without impacting market prices.

SEBI’s intervention primarily revolves around the imposition of caps on investments in small-cap stocks within mutual funds. The regulator has proposed limiting mutual fund schemes’ exposure to small-cap stocks to mitigate risks arising out of volatility and liquidity, with an aim to protect investor interest.

Additional Disclosures:

The regulator has required disclosures around valuation, volatility, investor concentration, and the percentage holding in small and mid-cap stocks, along with disclosures on stress testing results.

Impact on Investors:

Small and Mid-caps witnessed a significant correction as a result of this announcement. However, we don’t recommend exiting one’s investments. Small and Mid-Caps offer a good diversification strategy and are an important portion of your portfolio. The announcement from the regulator could lead to a short-term dip in your portfolio, however, this will bring in better disclosure norms and lead to a more transparent portfolio. These steps will lead to better liquidity management and will ensure investors interests remain protected.

For an investor, it’s important to ensure that their portfolio is well diversified and that they are investing based on their long-term goals. Building financial discipline is of utmost important when it comes to building a portfolio that gives investors positive returns over the long-term. Market aberrations and volatility across sectors/categories are largely cyclical in nature, the impact of which will be felt over the short term. Over the long-term however, small and mid-cap stocks that are based on in-depth fundamental research are an important part of an investor’s portfolio.