Why Morgan Stanley Sees Small And Mid Caps Staging A Comeback

Large-cap stocks have been driving India’s equity market for the past 30 months. But small and mid caps, according to Morgan Stanley, are now ready to make a comeback on the back of a growth recovery and attractive valuations.

Between the end of 2017 and March 2020, the small- and mid-cap indices were down more than 40% relative to the S&P BSE Sensex, according to a report authored by Ridham Desai, equity strategist, and Sheela Rathi, equity analyst, at the global research firm.

The underperformance was fuelled by a series of policy announcements such as the implementation of the goods and services tax, the Real Estate Regulation Act, the bankruptcy code and the new inflation framework—all of which may have dragged down growth in the near term even if they were positive for long-term growth, it said. “Demonetisation in November 2016 may have been a bigger drag on medium-term growth than was believed at the time, if the steep fall in monetary aggregates and their subsequent slow recovery is an indicator. These policy actions may have been particularly difficult for smaller firms.”

The growth slowdown, according to Morgan Stanley, buoyed the share of profits of large companies (Sensex constituents) from a low of 38% at the end of September 2017 to 54% in the quarter ended March 2020. That’s almost back to the all-time high of 56% hit in the aftermath of the global financial crisis.

Besides, the small and mid caps were trading at 50 times trailing earnings at the end of 2017, more than twice the multiple of the Sensex. The relative price-to-book of small and mid caps was 0.9 times the large-cap index, well above its 25-year average of 0.6 times, the report said.

The onset of Covid-19 and the subsequent lockdown worsened matters for the smaller firms, Morgan Stanley said, as it pushed some small businesses to the brink of closure. High unemployment and risk aversion in the banking sector compounded the problems. Yet, the forward-looking stock market has stopped penalising the small- and mid-cap cohort since the end of March 2020, it said, adding the reversal in relative performance of such stocks that began in April 2020 is likely to continue.

Once the impact of the Covid-19 ebbs, the cumulative policy response, including corporate tax rate cut, sector-specific steps for housing, exports, and autos, coupled with monetary system normalisation should once again bring back growth, the report said. That’s because such stocks have higher operating leverage—greater proportion of fixed costs in the total cost structure—and higher financial leverage—greater debt relative to equity—compared to large caps.

Even the valuations of small and mid caps are looking attractive relative to GDP and money supply, setting the stage for a re-rating if growth outlook improves, the report said. The relative price-to-book is down to 0.75, though above the long-term average. The informative valuation metrics like market cap ex-Nifty to GDP and market cap ex-Nifty relative to money supply are trading below averages and off their respective lows.

Still, some concerns remain.

• If the impact of the Covid-19 deepens, India could face another lockdown. This could impact the performance of small- and mid-cap stocks.
• If India fails to increase the much needed structural reforms it could once again polarise market behavior towards the large-cap stocks.
• The stress in the financial system could act as a hindrance to the growth of small- and mid-cap stocks.
• There is a trust gap between lenders and borrowers, keeping the loan growth sluggish. Also, the risk aversion in the financial system hurts smaller enterprises more than larger firms, which have stronger balance sheets.