JPMorgan-India Equity Strategy Small and Mid Caps - Froth or Not-107108752

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Global Markets Strategy

19 March 2024

JPMORGAN

www.jpmorganmarkets.com

Equity Macro Research

Rajiv Batra AC

(65) 6882-8151

rajiv.j.batra@jpmorgan.com

J.P. Morgan Securities Singapore Private Limited

Mixo Das

(852) 2800-0511

mixo.das@jpmorgan.com

J.P. Morgan Securities (Asia Pacific) Limited/ J.P.

Morgan Broking (Hong Kong) Limited

Khoi Vu, CFA

(65) 6882-8170

khoi.t.vu@jpmorgan.com

J.P. Morgan Securities Singapore Private Limited

Nifty Midcap 100 and Nifty Smallcap 100 logged their last intraday all-time highs

of 49,780 and 16,691, respectively, on 8 Feb and then lost 9% and 16% to their lows

on 14 Mar driven by regulatory vigilance and the seasonal March phenomenon

(when investors tend to lighten their portfolio for tax harvesting and for advance

tax payment by 15 Mar). We think the SMID space could remain volatile in the

coming weeks (India market volatility in election years tends to rise from end-

March), with margin funding and investor flows adding to risks. Judging by

previous corrections in the SMID space, there could be 5-10% further downside

from here. However, SEBI’s stress test on SMID funds highlights ample liquidity

that should help limit the risk of an extended or sharp sell-off. Beyond near-term

volatility, we believe SMIDs offer higher exposure to favorable themes like

manufacturing, infrastructure development, EV, digital transformation, green

energy and sustainability; and have historically offered higher Sharpe ratios and

higher alpha opportunities. These higher returns are driven by superior earnings

growth CAGRs for mid caps/small caps, estimated to be +60%/+24% respectively

for CY2021-25. Higher growth also supports a valuation premium, in our view,

which for mid-caps has now pulled back from 38% at end-Jan to 23% now (close

to the 19% average since 2019). In our view, the recent correction creates

opportunities to accumulate quality stocks in the SMID space in India. See

Figure 30J.P. Morgan covered stocks with OW/N ratings (<$5Bn) for a screen of high quality stocks in India smaller than US$5bn.

•What happened? The mutual fund body (AMFI) issued a notice after

Securities and Exchange Board of India (SEBI) flagged concerns about a

potential buildup of speculative activity in the small- and mid-cap segments.

This was followed by RBI’s actions against a couple of NBFCs to halt gold

loans and suspend loans against debentures and shares (for IPO financing and

NCD subscriptions) due to deficiencies in its processes. This curbs lending and

to an extent has a direct bearing on liquidity. Regulators’ comments came on

the back of the rapid rate at which small- and mid-cap stock prices have been

rising over the past year, much of it fueled by domestic inflows. In 2023, mid-

cap mutual fund schemes saw inflows of INR 229 billion (US$2.8bn), and

small cap schemes saw INR 410 billion (US$4.9bn). On the other hand, large

cap schemes saw an outflow of INR 29 billion (US$350mn). Despite this

decline in the last one-and-a-half months, the Nifty Midcap 100 Index and

Smallcap 100 index are up 65% and 56%, respectively, for FY2023-24.

•Volatility could persist near-term, driven by election, margin funding, and

flows. (1) We believe there could be 5%-10% further downside risk in the

small-cap and mid-cap indices based on the median correction witnessed in the

past (Figure 9Historical correction and rebound in small and mid caps). (2) India’s Election Commission announced the timing (19 Apr

to 1 Jun) for the upcoming general elections, with counting on 4 Jun.

Historically, the market has tended to see an extended period of elevated

volatility into elections, which then declines sharply post election (Figure 7Performance around General Election ).

(3) The rise in margin financing for trading (Figure 8Margin Trading Funding Book (INR Bn)) raises the risk of margin

selling triggers should there be substantial drawdowns. (4) The tide seems to

be slowing for small-cap funds. While the small-cap category continued to see

See page 10 for analyst certification and important disclosures.

J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that

the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single

factor in making their investment decision.

India Equity Strategy

Small and Mid Caps - Froth or Not?

Rajiv Batra AC

(65) 6882-8151

rajiv.j.batra@jpmorgan.com

Global Markets Strategy

19 March 2024 JPMORGAN

robust inflows of INR 29 billion in February, this was down 10% compared to January,

which was already down from December.

•Stress test results indicate decent liquidity for small and mid caps. Results of the

small-cap and mid-cap fund stress test initiated by SEBI are less concerning, in our view.

Among the largest small- and mid-cap funds, the median small-cap fund would likely

need 5 days to exit 25% of their portfolio (10 days for 50%). Similarly, the median mid-

cap fund would take 2 days and 4 days to sell 25% and 50% of their portfolios,

respectively. Notably, liquidity in the SMID space has increased substantially in recent

years, and is likely to improve further as global money starts to invest beyond the

traditional large-caps. See Figure 10BMid Cap funds stress test results (AUM>INR 1000 cr) and Figure 11.Mid Cap funds stress test results (AUM>INR 1000 cr)Mid Cap funds stress test results (AUM>INR 1000 cr)

•Opportunities to buy structural growth plays. While downside risks remain for small

and midcaps in the near term, we are not bearish on mid-cap/small-cap in the longer term,

considering the indices’ higher exposure to favorable themes like manufacturing,

infrastructure development, EV, digital transformation, green energy and sustainability.

Historically, mid-caps and small-caps have higher volatility than large caps, but the

outperformance more than makes up for it. As a result, Sharpe ratios are higher in the

SMID space. This is particularly true since 2020. Earnings growth CAGRs for mid caps/

small caps are estimated to be +60%/+24% respectively for CY2021-25, compared to

CAGRs of -1.8%/0.4% over CY2011-20. This is driven by strong infrastructure push,

pro-industry policies and government spending. In addition, dispersion in SMIDs is also

more than 50% higher compared with the large-cap space in recent years, highlighting

opportunities to generate alpha from stock selection.

•Sharp correction brings value back. The premium valuations of Nifty Midcap 100

(NSEMCAP) and Nifty Smallcap 100 (NSESMCP) vs. Nifty 50 have started to

consolidate after reaching record levels (Figure 5Nifty Midcap 100 premium trading near their average relative to Nifty 50 & Figure 6Nifty Smallcap 100 premium to Nifty 50 dissipates after the recent fall). NSEMCAP traded at

+38% higher P/E than Nifty 50 at its peak in January. This premium is now at 23%. We

think this correction is an opportunity to accumulate quality mid-cap/small-cap stocks at

acceptable valuations. Median 12-month forward returns post correction are +53%/

+64% in mid-cap/small-cap (Figure 9Historical correction and rebound in small and mid caps). We believe diversification across a wide range

of stocks can provide a buffer in volatile market conditions, ensuring stability even in the

face of market pressures.

Key Charts

Figure 1: SMid beating large caps over longer term

Period Nifty 50 Nifty Midcap 100 Nifty Smallcap 100

YTD 1.2% 0.4% -2.8%

Since 2023 21.5% 48.1% 52.0%

5 Year CAGR 14.0% 21.2% 17.7%

10 Year CAGR 13.0% 19.2% 15.9%

20 Year CAGR 13.4% 16.6% 15.6%

Source: Bloomberg Finance L.P., J.P. Morgan. Note: YTD Perf as of 15th Mar.

Figure 2: SMid to deliver stronger growth over 2021-2025E period

5.6%

21.2%

-1.8%

60.1%

0.4%

24.1%

-10.0%

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

2011-2020 2021-2025E

Nifty 50 NSE Mdicap 100 NSE Smallcap 100

Source: Bloomberg Finance L.P., J.P. Morgan. Note: EPS growth CAGRs over respective periods

Rajiv Batra AC

(65) 6882-8151

rajiv.j.batra@jpmorgan.com

Global Markets Strategy

19 March 2024 JPMORGAN

Figure 3: Risk-reward trade-off looks better for SMid

0.0

0.5

1.0

1.5

2.0

2.5

Average since 2011 Average since 2020

NIFTY 50 Nifty Midcap 100 Nifty Smallcap 100

Source: Bloomberg Finance L.P., J.P. Morgan. Note: 6m rolling avg Sharpe ratio.

Figure 4: Dispersion in SMid is more than 50% higher than for large caps

in recent years

10%

20%

30%

40%

50%

60%

70%

80%

90%

2019 2020 2021 2022 2023 2024

Nifty 50 Nifty Midcap 100 Nifty Smallcap 100

Source: Bloomberg Finance L.P., J.P. Morgan. Note: 80th - 20th percentile of 6m rolling performance,

3mma.

Figure 5: Nifty Midcap 100 premium trading near its average relative to

Nifty 50

0.6

0.7

0.8

0.9

1.0

1.1

1.2

1.3

1.4

1.5

1.6

2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023

12m Fwd P/E Average since 2019

Source: Bloomberg Finance L.P., J.P. Morgan

Figure 6: Nifty Smallcap 100 now trading at a discount relative to Nifty 50

0.5

0.6

0.7

0.8

0.9

1.0

1.1

1.2

2018 2019 2020 2021 2022 2023

12m Fwd P/E Average since 2019

Source: Bloomberg Finance L.P., J.P. Morgan

Figure 7: Nifty implied volatility tends to rise around start of elections and

fall on conclusion

-100 -90 -80 -70 -60 -50 -40 -30 -20 -10 0 10 20 30 40 50

Average of 2009, 2014, 2019

Days post election

Days before election

Source: Bloomberg Finance L.P., J.P. Morgan

Figure 8: Margin Trading Funding book hitting record high (INR Bn)

200

250

300

350

400

450

500

550

600

Mar-22 Jun-22 Sep-22 Dec-22 Mar-23 Jun-23 Sep-23 Dec-23

Source: BSE, NSE, J.P. Morgan

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GlobalMarketsStrategy19March2024JPMORGANwww.jpmorganmarkets.comEquityMacroResearchRajivBatraAC(65)6882-8151rajiv.j.batra@jpmorgan.comJ.P.MorganSecuritiesSingaporePrivateLimitedMixoDas(852)2800-0511mixo.das@jpmorgan.comJ.P.MorganSecurities(AsiaPacific)Limited/J.P.MorganBroking(HongKong)LimitedKhoiVu,...

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