The continued rally of the past three months has pushed the mid and small caps five-year outperformance ahead of the 10-year outperformance, thereby closing the gap, Elara Securities said in a report. Hence, the room for further catchup outperformance is limited, in our view.

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The Nifty Midcap Index P/E at 24.2x is almost at its 2017 peak at 24.5x. The Nifty Smallcap Index P/E at 21.6x has crossed the previous peaks in 2015 at 17.6x and 2017 at 18.3x. The small cap valuation relative to the Nifty is at or around the previous peak of 9 per cent in 2015.

Midcap valuation relative to the Nifty (premium of 21 per cent) is at or around the previous peak except for a brief window in 2017, the report said. Unlike in September 2023, we see limited room for further outperformance of mid and small caps to large caps.

Further, unlike in September 2023, we see fewer stocks where valuation is still inexpensive. FII inflows into India-dedicated midcap funds as a percent of midcap free-float market cap peaked in August and has collapsed in October and November, the report said.

However, domestic flows into mid and smallcap mutual funds as a percent of free-float market cap are still near all-time highs. Additionally, largecap plus cash holding in smallcap MF schemes is at all-time high and has hurt the performance of funds, it said.

Continued domestic flows together with increased pressure on funds to deploy excess cash would drive a near-term accelerated rally in mid and small caps, which will likely be the last leg of mid and small cap outperformance, in our view, the report said.

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