‘Stocks with no history or future’: Kotak drops its midcap portfolio as valuations soar

Even though the recent rally in the midcap stocks seems invincible, brokerage house Kotak Institutional Equities has dropped its recommended mid-cap portfolio since it cannot find too many stocks beyond the BFSI (banking, financial services, and insurance) space that offer decent potential upside to its 12-month fair value.

"We see a limited point in trying to find fundamental reasons behind the steep increase in stock prices of several mid-cap. and small-cap. stocks. There is no meaningful change in the fundamentals of most companies; in fact, they have worsened in many cases. The primary driver of the rally appears to be irrational exuberance among investors, with high return expectations (and purchase decisions) being driven by the high returns of the past few months," explained the brokerage as the reasons behind this decision.

Nifty Midcap & Smallcap trend

The Nifty midcap and smallcap index have been consistently hitting new peaks in September. Just in the previous session, on September 12, the Nifty Midcap 100 index hit another record high of 41,686.75, breaching the 41,000 mark for the first time ever, soaring around 43 percent from its 52-week low of 29,200.20, hit in March 2023.

Similarly, the smallcap index also hit its latest peak of 13,079.20, crossing the 13,000 level for the first time, rallying over 50 percent from its 52-week low of 8,682, hit in March 2023.

In comparison, the benchmark Nifty has advanced 20 percent from its 52-week low of 16,747.70, hit during the same time.

Both Nifty Midcap and Nifty Smallcap indices have surged almost 28 percent and 29 percent, respectively, in 2023 so far as against a 10 percent jump in Nifty. Meanwhile, in the last one year as well, the Nifty Midcap and Nifty Smallcap indices have rallied over 24 percent each versus an over 11 percent gain in Nifty.

The midcap index has been positive in 6 of the 9 months so far this year. It was in the red in the first 3 months of the year. It rose the most in May, gaining 6.19 percent and shed the most in Jan, down 2.64 percent.

The trend is the same for the smallcap index. It rose in 6 of the 9 months so far this year and fell in the first 3 months of the year. It rose the most in July, gaining 8 percent and shed the most in Feb, down 3.64 percent.

After correcting earlier this year, the broader market stocks had favorable valuations which led to rising investor interest. But now that valuations of mid and smallcaps have recovered strongly, experts advise investors to remain cautious before heavily investing in these stocks.

Kotak drops the recommended midcap portfolio

The brokerage house pointed out that most of the non-BFSI stocks in its previously recommended midcap portfolio are trading above at around 12-month fair values.

Kotak believes that the valuations of stocks in its favorite capital goods, healthcare, QSR and real estate sectors discount growth for the next few years and leave absolutely no room for any disappointment.

"We would have had to remove these stocks from the portfolio anyway, as it would be incorrect to recommend stocks with low conviction and potential downside to our Fair Values, which would have left a portfolio comprising BFSI stocks largely," stated the brokerage.

It further noted that many of the stocks (from its portfolio) have jumped in the past few months (some within weeks of inclusion in the portfolio).

“Many of the stocks have jumped in the past few months (some within weeks of inclusion in the portfolio). We have changed the portfolio frequently in the past few months to keep up with rampant stock prices, but have largely run out of options now. It is obvious that we have not developed some special stock-picking skills recently. In our view, the steep increase in stock prices simply reflects the irrational exuberance of investors in the midcap and small-cap parts of the market,” Kotak Institutional Equities said.

Here's a look at its previously recommended midcap portfolio.

4 reasons behind the drop

Varying degrees of exuberance in the mid and small-cap space: The brokerage observed that it does not see many fundamental reasons for the meteoric rise in the stock prices of many mid and smallcap stocks in the past few months. The fundamentals of most sectors have not changed much. However, it stated that market sentiment is quite exuberant, based on (1) a steep increase in the prices of many mid and small-cap stocks, (2) large inflows into mid and small-cap. mutual funds and (3) a huge number of new retail participants in the mid and small-cap funds. The strong performance of the mid and small-cap indices has possibly pushed up return expectations among retail investors, it said.

Stocks with great history (but potentially less favorable future): As per the brokerage, most of the traditional favorite midcap stocks of institutional investors in the broader ‘consumption’ sector have been large laggards in the ongoing rally, given weak consumption demand in general. However, the valuations of these companies have stayed high or gone to historically high levels due to earnings cuts. The brokerage sees risks of (1) lower profitability and (2) lower valuation multiples due to weakening business models (erosion of business moats of brand, distribution market structure and product).

Stocks with great purported future (but mediocre history): Kotak informed that many of the new favorite mid and smallcap stocks of institutional and retail investors are in the broader ‘investment’ sector (capital goods, defense, EMS, railways, real estate, renewables). These stocks have delivered eye-popping returns in the past 3-6 months, led by the broader ‘investment’ narrative. We expect a decent investment cycle, but the brokerage is not sure about the quality of many of the stocks given their historically weak execution and governance track records. In addition, many of these sectors fall in the B2G (business-to-government) or B2B categories, which raises issues around execution and profitability. It believes that market expectations for both revenues and profitability may be too optimistic across these sectors.

Stocks with no history or possibly future (but why not?): The last lot of the new favorite mid and smallcap stocks fall in the dubious category of ‘turnaround’ stories, noted the brokerage. Many of these companies have been through serious operational and financial challenges (including bankruptcy) in the recent past, but the market has high hopes of these companies doing well in the future. The brokerage said that it is not sure of the basis of the market’s confidence.

Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of MintGenie. We advise investors to check with certified experts before taking any investment decisions.