SEBI risk disclosure norms and high valuations, key reasons behind correction in mid & smallcaps

The NIFTY Midcap 100 and Smallcap 100 indices have experienced a sharp correction over the past three consecutive days. The small-cap index has delivered impressive returns of 83% over the previous 12 months, while the mid-cap index has posted gains of 65% during the same period. Following this stellar rally, stocks in these categories are now witnessing significant corrections. Below are some key reasons contributing to this sharp decline.

Tighter regulation

The Securities and Exchange Board of India (SEBI) has issued warnings regarding the frothiness observed in midcap and small-cap stocks, particularly after many loss-making companies witnessed substantial rallies in the past year. SEBI has directed the Association of Mutual Funds India (AMFI) to ensure that asset management companies (AMCs) prepare risk disclosures for investors regarding mid-small cap schemes.

As a result of these disclosures and stress tests, mutual funds may consider reducing their exposure to midcap and small-cap stocks, which have performed exceptionally well over the past year. Consequently, we may witness a sharp correction in certain small-cap and midcap stocks over the last three days.

Additionally, mutual funds were instructed to conduct stress tests on such schemes to assess their ability to handle redemption pressures in uncertain market conditions. The results of the first stress tests are expected by March 15, as per AMFI's directive. Over the past few months, midcap and small-cap schemes have seen higher inflows of money through mutual funds compared to large-cap and other schemes. These funds are required to invest a minimum of 65% in stocks from these specific categories.

Valuations

Midcap and small-cap stocks are often low-liquidity stocks, meaning sudden demand can lead to significant rallies, while sudden supply can result in sharp corrections. When these stocks experience rapid appreciation, their valuations can become expensive, exceeding their actual earnings growth. Industry experts and mutual fund managers believe there is significant frothiness in midcap and small-cap stocks, with valuations becoming stretched, thereby increasing the risk of correction.

Manipulation

Recent investigations by SEBI have uncovered instances of outsider entities manipulating stocks in the small-cap and micro-cap space. Such fraudulent activities create a negative sentiment in the markets and can impact the overall health of the capital markets functioning.

Thus, we are seeing sharp corrections in stocks, which have run up more than 100% in the last one year. The NIFTY Microcap 250, which nearly doubled in a year, has seen a sharp correction of more than 15% in the last one month. SEBI has recently observed manipulation of price on the issuance as well as regular trading in some of SME stocks. Further investigation is awaited in the space, making the overall sentiment cautious for the investors.