India's Small-Cap Stocks Rebound, Nearly Erasing Losses Amid Regulatory Concerns

India's small-cap stocks rebound, erasing nearly all losses from a $80 billion rout, signaling investor confidence amid regulatory scrutiny.

By Athena Xu

4/4, 03:14 EDT

Key Takeaway

  • India's NSE Nifty Smallcap 250 Index rebounds, nearly erasing losses since Feb 27 due to SEBI's bubble warning, signaling strong investor confidence.
  • Despite an $80 billion rout in March, domestic institutions invested a net $6.8 billion in shares, the highest since March 2020.
  • Economic shift towards manufacturing boosts small-cap stocks, attracting nearly 40% of 2023's net inflows of $19.5 billion.

Small-Cap Recovery

India's small-cap stocks have shown resilience, bouncing back from a month-long downturn triggered by regulatory concerns over market froth. The NSE Nifty Smallcap 250 Index witnessed a rise of up to 1.1% on Thursday, nearly erasing the losses incurred since February 27, when the Securities and Exchange Board of India (SEBI) highlighted the risk of a bubble in smaller firms. Despite a slight paring of gains, the index is on its longest winning streak since December and is merely 1% shy of its February peak. Ram Kalyan Kumar Medury, CEO of Jama Wealth, advised clients to maintain their small-cap investments, highlighting the growth potential of companies valued over $500 million within this segment.

Regulatory Measures and Market Impact

The SEBI's directive for mutual funds to implement measures protecting investors from speculative bubbles in small-cap stocks led to a significant market value loss exceeding $80 billion in the S&P BSE Small Cap Index over two weeks in March. The regulator's recommendations included conducting periodic stress tests to evaluate the liquidity of small-cap fund portfolios during downturns. Despite these challenges, domestic institutions demonstrated confidence by investing a net $6.8 billion in shares, marking the highest purchase since March 2020, as the small-cap index faced its most substantial monthly drop since June 2022.

Economic Shifts and Investment Flows

The shift in India's economic growth trajectory towards manufacturing and investment has prompted a redistribution of the incremental profit pool, moving away from sectors dominant in the large-cap universe, such as banks, fast-moving consumer goods, and information technology. This shift, noted by Emkay Institutional Equities, has fueled optimism among investors. The small-cap segment's robust performance, despite regulatory concerns, has attracted nearly 40% of the net inflows of $19.5 billion in 2023, underscoring the continued interest in these investments.

Valuation Concerns and Market Outlook

Despite the recent recovery, small-cap stocks in India face valuation concerns, with the NSE small-cap gauge's 14-day relative strength index nearing levels that some traders interpret as overbought. Analysts, including Shrikant Chouhan from Kotak Securities Ltd., anticipate that the indexes may stabilize before undergoing consolidation. The regulatory scrutiny and the subsequent market correction have been viewed by some investors as an opportunity to buy into high-quality, well-managed companies at more attractive prices, suggesting a potential comeback for small-cap shares.

Street Views

  • Ram Kalyan Kumar Medury, Jama Wealth (Bullish on India's small-cap stocks):

    "We have advised our clients to not exit small caps. This segment has many companies valued at more than $500 million that can grow into large caps, and investors should not respond to any knee jerk reaction."

  • Shrikant Chouhan, Kotak Securities Ltd. (Neutral on India's small-cap stocks):

    "The recovery in small-caps is beyond our expectations... The technicals are projecting that the indexes may hold the levels for some time before consolidating."