MUMBAI: Analysts are cautious that valuation-defying record rally in mid- and small-cap stocks are risky and the surge may not sustain. According to analysts at JM Financial, mid- and small-caps are in a bubble.

“We maintain our previous precautionary view on the small and mid-cap indices, which have made new highs on relative valuation versus Nifty. Smallcap index reached 83% of Nifty price to book, topping the peak of 82% in January 2018. Comparatively, the mid cap index at 78% is lower than 88% in January 2018," JM Financial said in a report.

BSE Small and BSE Midcap indices slipped 2-4% in trade during Monday-Wednesday following a BSE circular on survelliance measures to curb volatility. However, analysts had said it was a knee jerk reaction and a correction in the segments was long due, as these stocks have seen a massive rally especially since pandemic hit in March 2020.

Since March last year, BSE Midcap and BSE Smallcap indices have jumped 134% and 192% respectively, outpacing 110% gains in Sensex and 114% in Nifty. In 2021 so far, BSE Midcap has surged 26% while BSE Smallcap has risen 43% whereas Sensex has climbed 14% and Nifty 16%. However, in August so far, both BSE Midcap and BSE Smallcap have declined 2-3.5% compared to gains of 3-4% in Sensex and Nifty.

A follow-up clarification by BSE on surveillance measures finally soothed investors' nerves. The exchange said its new surveillance rules will be restricted to certain stocks. It added that the new rules will be imposed on only those securities which meet a specific criteria set out by BSE and will be effective from 23 August.

According to an analysis by JM Financial of BSE500 of select 195 stocks from key industries indicates that over the past one year retail investors were lead buyers in 58 stocks and FII in 73, and 60% of these came from domestic funds. Domestic funds and promoters were lead buyers in 50 and 14 stocks, respectively.

Further, FII were proportionate lead buyers across small (27 stocks), mid (22) and large cap (24) stocks. Retail were leads in 35 small cap stocks. Domestic funds were proportionate leads in small (21) and Mid Caps (19).

“Consensus earnings growth (FY23 over FY20) across small (38%YoY), mid (32%) and large caps (37%) are optimistic and broadly similar. Thus, unlike the 2017 mid and small cap boom, the risk to liquidity tapering and valuation correction is higher this time due to higher component of discretionary retail money and even FIIs participating in mid and small caps," JM Financial said.

JM Financial feels that considering the relative valuation and change in ownership across stocks, large caps can perform better going forward. “Trailing price to earnings (PE) for Nifty has moderated to 26.5 times from 29 times month-on-month and we continue to see this settling lower at 24 times. The Nifty is already close to our scaled down 12 months target of 16500, which assumes earnings per share (EPS) growth at 18% for FY22-23E versus consensus 32%; margin pressure emerging from Q1FY22 results corroborate our less optimistic expectations," JM Financial added.

According to ICICI Securities since June 2020 Nifty midcap and small cap indices have maintained the rhythm of not correcting for more than 9% while sustaining above 50 days exponential moving average (EMA). “In current scenario, both indices have already corrected 6% & 8% respectively from all-time high and witnessed buying demand near 50 days EMA. We expect them to maintain rhythm by arresting ongoing correction in coming sessions and undergo base formation," ICICI Securities said.