Navigating Market Froth in Small- & Mid-caps: Strategies for Retail Investors

Are investors over-boarding Small &Midcap segments?

The current rally in small mid-caps is also raising eyebrows due to stretched valuations and signs of market froth.

As you can see, the Small & Mid-cap cap indices have significantly outperformed the broader equity in the year 2023. This has led to a spike in small and mid-cap mutual funds investment in recent months.

The big concern of SEBI is whether the mid & small cap segments have the capabilities to withstand the turbulence waves like sharp market selloffs.

Successful investing is about managing risk, not avoiding it. – Benjamin Graham.

Is there a bubble in small-cap stocks?

If yes, then as an investor, how to handle this bubble?

Experts caution that the combination of high liquidity and froth in the markets can make small and mid-cap stocks more vulnerable to sudden corrections.

This article focuses on raising SEBI’s concerns over stretched valuations of small and mid-cap stocks.

Further, the discussion is about how to survive the froth.

Table of Contents

1.)What is SEBI concerned with?
2.)What are the Measures taken by AMFI?
• Managing Inflows & Rebalancing portfolios
• Stress test
3.)What is the current valuation of SMEs?
4.)How to survive the Froth?
5.)What are the Benefits of associating with Holistic Investment Planners?
6.)Conclusion

1.) What is SEBI concerned with?

SEBI Chairperson Madhabi Puri Buch pointed out that there are pockets of froth in the market which are like bubbles.

She added that SEBI has evidence of price manipulation in the initial public offerings (IPOs) and trading in the shares of small and medium enterprises (SMEs) in the secondary market.

Such froth in market conditions is particularly risky for small mid-caps, where liquidity can dry up quickly during downturns.

Along with it she also remarked that it appears like ‘Irrational Exuberance’ as the valuation parameters are not supported by fundamentals.

Small & Mid Cap’s froth has shown signs of becoming a bubble which upon bursting can badly affect investors.

SEBI advised the investor to be more cautious while investing in risky segments.

Highlighting this concern, SEBI wrote to the Apex body of Mutual fund – AMFI.

Market froth liquidity problem is one of the core issues SEBI aims to address in this segment.

In the context of the froth building up in the small and midcap segments of the market and the continuing flows in the small and midcap schemes of mutual funds, Trustees, in consultation with Unitholder Protection Committees of the AMCs, shall ensure that a policy is put in place to protect the interest of all investors,” the AMFI letter dated February 27 said.

The market regulator has requested the implementation of a policy aimed at safeguarding investors. The letter outlined two specific requirements for this policy.

2.) What are the Measures taken by AMFI?

SEBI’s concern prompted the Association of Mutual Funds in India (AMFI) to direct Mutual Fund Asset Management Companies (AMCs) to take the following two steps immediately.

Firstly, it called for suitable and precautionary actions to be undertaken by Asset Management Companies (AMCs) and fund managers to safeguard investors, such as managing inflows and rebalancing portfolios.

Mid cap small cap exposure is now being closely monitored to prevent excessive risk-taking by fund managers.

Secondly, it urged the adoption of measures to guarantee that investors are shielded from the first-mover advantage of redeeming investors (any advantages gained by redeeming investors who act first).

This means in case of a market crash, investors who redeem first can disproportionately benefit at the cost of those who stayed with the investment.

This prompted AMFI to ask AMCs to go for stress tests and asses the time taken to exit the position when the market mood is bearish.

In a froth in the markets scenario, these stress tests become even more important for small and mid-cap funds.

Managing Inflows & Rebalancing portfolios

For the entire calendar year 2023, small-cap funds witnessed net inflows of Rs 41,035 crore, while midcap funds witnessed net investments of Rs 22,913 crore, accounting for a total of 40% of total flows garnered by all equity funds.

This massive inflow into small mid-caps has been one of the driving forces behind the current valuation surge.

This shows how investors are drawn by the impressive performance numbers.

After SEBI’s & AMFI’s direction, all Mutual Fund Asset Management Companies have announced the restriction on future investments.

This is another sign that market froth liquidity problem concerns are now being addressed head-on by the industry.

As a result, many Mutual Fund Schemes are closing doors, especially for Lumpsum investment in Small- & Mid- Capped Schemes.

In the year 2023 itself, Nippon India Life Asset Management & Tata Mutual Fund announced that it would not accept Lumpsum investments into Nippon India Small Cap Fund & Tata Small Cap Fund respectively.

Kotak Mutual Fund Company capped the investment amount to ₹2 lakhs per PAN (first holder or guardian) per month for any lump sum investments, including additional investments or switch-ins.

The company, however, did not touch the systematic investment plan (SIP) and systematic transfer plan (STP) registrations with a monthly limit of ₹25,000 per PAN for various frequencies.

Stress test

The Association of Mutual Funds in India (AMFI) has instructed the Mutual funds AMCs to go for stress tests once every 15 days and disclose outcomes starting from March 15 onwards.

Such measures are vital when froth in the markets can amplify redemption pressure in small mid cap funds.

This move is aimed at assessing the time taken to exit the position in a weak market.

Few fund houses began releasing their test reports this week. The following is the list of fund houses.

Firstly, Quant Mutual Fund has announced that the time taken for 50% portfolio liquidation is 6 days for its Quant Mid Cap Fund and 22 days for the Quant Small Cap Fund.

Furthermore, the time consumed to liquidate a 25% portfolio is 3 days for the Quant Mid Cap Fund and 11 days for the Quant Small Cap Fund.

Secondly, it is Edelweiss Mutual Fund said it would take 2 days to liquidate half the portfolio of its midcap fund and one day for a quarter of it.

For the small-cap fund, the fund house said it would need 3 days and 2 days, respectively.

Thirdly, Nippon India said it would take 27 days to liquidate 50% of its small-cap fund, the largest scheme in this category, and 7 days in the midcap fund.

The results disclosed by the DSP Small Cap Fund were disheartening.

The fund house said it would take 16 days to liquidity 25% of its portfolio and a staggering 32 days to liquidate 50% of its portfolio, which is the highest among funds that have disclosed their stress tests till now.

Stress Test Results	Time taken to liquidate the Portfolio
Fund Name	50% of Portfolio	25% of Portfolio
Quant Midcap Fund	6 days	3 days
Quant Smallcap Fund	22 days	11 days
Edelweiss Midcap Fund	2 days	1 day
Edelweiss Smallcap Fund	3 days	2 days
Nippon India Midcap Fund	7 days	4 days
Nippon India Smal cap Fund	27 days	13 days
DSP Midcap Fund	17 days	9 days
DSP SmallCap Fund	32 days	16 days

Fund houses are publishing their stress test result on their respective AMC website.

The data shown here is as of 16 Mar 2024.

For small and mid-cap investors, tracking such data is crucial in understanding hidden liquidity risks.

Use this link for consolidated data of all fund houses which is updated as when the fund house releases the data.

3.) What is the current valuation of SMEs?

The S&P BSE Mid Cap index is currently trading at a trailing Price-to-Earnings (P/E) multiple of 28X while the BSE SmallCap index is trading at a trailing P/E of around 28.50X.

This high valuation level is a clear indicator of froth in market sentiment toward small & mid-caps.

In comparison, the Sensex is trading at a trailing P/E multiple of around 24.84X currently.

How long the stretched valuations will continue? Historically, excessive excitement over a prolonged period is never a good sign.

The Small & Midcap have started bearing the brunt of panic selling. Here is a brief summary of historical data.

Percentage decline from the peak for the BSE Small Cap Index after a bull market high:
2008-09	-80%
2010-13	-55%
2015-16	-22%
2018-20 (including COVID decline)	-57%
The current decline from peak:
2024	-14%

For investors in mid cap small cap categories, past cycles serve as a reminder that corrections can be deep and prolonged when valuations are stretched.

Concern flagged by SEBI & responsive corrective measures taken by AMFI have resulted in the sharp correction which is long warranted. However, the Indian market is poised for a bounce back after a sharp correction.

If you look at the key benchmark indices, they witness a bounce-back after every fall. As a retail investor, you should maintain a long-term perspective and avoid making hasty decisions based on short-term market movements.

4.) How to survive the Froth?

The Small & Midcap stocks have become the favourites of retail investors, who have been lapping them up via the mutual fund route.

While chasing returns in small and mid-cap segments can be tempting, it’s important to remember that market froth phases can reverse quickly.

The apex body wants to assure investors that their investments are being handled with meticulous care, and steps have been taken to safeguard their interests.

While it’s natural for the apex body to be concerned about a surge in inflows, it doesn’t necessarily mean you should rush to exit your investments. We believe that maintaining discipline in asset allocation is key, and as long as you adhere to the following principles, there’s no need to worry.

In light of the growing concerns about market froth, let’s explore some key strategies to help you navigate through these challenging times.

i) Stay Calm and Rational:

During periods of market volatility, it’s crucial to maintain a calm and rational approach. Assure yourself that the measures taken by regulatory bodies and fund houses are aimed at protecting investors like yourself.

ii) Diversify Your Portfolio:

Diversification is key to managing risk. Ensure that your portfolio is diversified across different asset classes, sectors, and fund categories. This helps in reducing the impact of volatility on your overall portfolio.

Small mid cap exposure should be balanced with large cap holdings to reduce overall portfolio risk.

To enlighten yourself better on Allocation Strategy we prescribe you to watch our video on:

Don’t place all your eggs in one basket is the best proverb to describe the importance of Diversification in your investments.

iii) Stick to Your Investment Plan:

It’s important to stick to your investment plan and avoid making impulsive decisions based on short-term market movements.

Your investment strategy should be aligned with your financial goals and risk tolerance.

Even in times of froth in market conditions, staying disciplined can protect you from costly mistakes.

iv) Avoid Chasing Performance:

Resist the urge to chase hot sectors or funds based solely on recent performance.

In phases of market froth, some small & mid-caps and mid cap small cap stocks may look attractive but could be overvalued.

Instead, focus on investing in fundamentally strong assets with sustainable growth potential.

If you are looking for more guidance on these areas of investments, we recommend you to read our blog post on:

How ‘NOT’ to Select a Mutual Fund to Invest?

v) Review and Rebalance Regularly:

Regularly review your portfolio and rebalance as needed to maintain proper asset allocation.

Periodic review helps to maintain the optimal asset allocation based on your risk tolerance.

This helps in adapting to changing market conditions and managing risk effectively — particularly important when there’s froth in the markets or market froth liquidity problem.

This helps in adapting to changing market conditions and managing risk effectively.

What impact will the Review have on your overall investments?

The answer to this can be found by clicking on the below video.

Do Your Homework:

Stay informed about the measures taken by fund houses, such as stress tests, to assess their preparedness during market downturns.

Conduct thorough research before making any investment decision and focus on the long-term prospects of your investments, especially in small and mid-cap segments where valuations can swing sharply.

Conduct thorough research before making any investment decision and focus on the long-term prospects of your investments.

If you find it hard to follow any of these strategies, consult a professional financial advisor.

Seek Professional Advice if Needed:

If you have concerns or need guidance with your investments, don’t hesitate to seek advice from a qualified financial advisor.

They can provide personalized strategies tailored to your financial objectives, including how to navigate market froth phases and manage exposure to small mid cap opportunities.

They can provide personalized strategies tailored to your financial objectives.

5). How Holisticinvestment.in helps?

At HolisticInvestment.in, we offer personalized investment strategies tailored to your unique financial goals and risk tolerance. Here’s why partnering with us provides you with significant advantages:

1) Allocation Strategy

Firstly, let’s talk about our allocation strategy for small and mid-cap funds.

We specifically choose these for your long-term goals and always opt for SIPs and STPs instead of lump-sum investments.

This shields your portfolio from short-term market swings, ensuring you stay focused on your objectives without worrying about temporary downturns.

In times of froth in the markets, our disciplined allocation helps investors avoid overexposure to overheated small & mid cap segments.

2) Risk Mitigation

When it comes to risk, we assure you that small and mid-cap allocations are tailored to your personal risk tolerance.

This means we’re optimizing returns while keeping risks within your comfort zone, providing you with the confidence to stay invested even during market corrections.

We never suggest investors have a concentrated portfolio of small-cap funds. We give the right balance and mix all capitalisation funds.

This balanced diversification strategy helps prevent your portfolio from falling victim to a market froth liquidity problem, which can hurt investors holding too many small mid-caps.

For insights regarding Risk Mitigation click on the link below:

3) Liquidity Assurance

Regarding liquidity concerns, our fund recommendations undergo rigorous research to ensure they maintain sufficient liquidity levels.

You can trust that your investments are in stable funds, minimizing any liquidity issues even during challenging market conditions.

You can check the stress test results mentioned above.

This is crucial because froth in market conditions often leads to sudden liquidity crunches, especially in small and mid-cap categories.

4) Avoiding Manipulated stocks

We want to emphasize that we steer clear of manipulated stocks or questionable companies in our recommended fund list.

Your investments are safeguarded through our ethical and diligent fund selection process, prioritizing your financial well-being.

5) Periodic rebalancing

Lastly, during our periodic reviews, we’ll rebalance your small and mid-cap allocations based on your evolving needs and goals.

This proactive approach ensures that your investment portfolio remains aligned with your objectives, providing you with peace of mind and a roadmap for long-term success.

Rebalancing becomes even more critical when the market shows signs of froth, as it allows you to reduce exposure to overheated smallcaps and safeguard long-term gains.

If you need any further clarification on Portfolio Rebalancing in your investments, we suggest you read our article on:

Portfolio Rebalancing Guide: The Blueprint for Financial Success

By partnering with us, you benefit from a personalized approach. We’re here to guide you through every step of your investment journey, especially during the period the heightened market volatility.

6.) Conclusion

In conclusion, sometimes the valuation seems lucrative, but you must remain vigilant and exercise caution, especially in the phase of market froth.

This is particularly true for mid-cap small cap segments, where excessive optimism can quickly reverse if liquidity dries up.

By following these strategies and maintaining a disciplined approach, you can navigate through market volatility with confidence.

Staying well-informed and making wise investment decisions, helps you in achieving long-term financial success.