Midcap mayhem: UBS says these factors weigh on small and midcap stock returns; should you buy shares?

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Published: June 4, 2018 2:36:18 PM

Even as the small and midcap stocks continue to see vicious selloffs in the recent months, global firm UBS says that the space interest rates and retail flows will weigh on the returns in the space.

Smallcaps have outperformed largecaps in key markets globally during most tightening periods, UBS said.

Even as the small and midcap stocks continue to see vicious selloffs in the recent months, global firm UBS says that the space interest rates and retail flows will weigh on the returns in the space. “Smallcap and midcap stocks (SMIDS) have outperformed largecaps in India, generally and compared with past peaks/bottoms but have recently underperformed, with more than 60% of listed stocks down 20% from their peaks,” UBS observed in the report. According to the firm, smallcaps have outperformed largecaps in key markets globally during most tightening periods. “Our analysis indicates a similar trend in India over the long term,” UBS said. We take a closer look at the factors that will decide the future course for small and midcap stocks.

Rising interest rates

According to UBS, small and midcap stocks have underperformed with rising interest rates, after outperforming during falling rates over the past three to four years, as growth has disappointed, as shown by earnings revisions. “We expect that rising interest rates may be an overhang for SMIDS’ relative performance. Over a longer term, SMIDS have outperformed in periods of rising rates, but this seems to have been supported by a favourable underlying economic growth environment, reflected in earnings growth,” Gautam Chhaochharia, Analyst, UBS Securities said in the report, adding that the economic growth cycle is less strong now, and the rate rise is not countercyclical.

Retail flows

UBS notes that mutual fund flows have clearly been more relevant than foreign flows and the impact has been greater than for largecaps. “Our analysis also suggests 1) local retail flows may moderate and 2) increased role of (more volatile) PMS for SMIDS. The best of local retail flows supporting SMID outperformance may be behind us, at least cyclically,” said the firm.

Should you buy/sell?

Rising interest rates will be an overhang on the small and midcap, as UBS expects disappointing recovery growth ahead. Further, the global research firm observed that flows are not as supportive as in 2017. “The overall market risk-reward seems to be unattractive at current levels and SMIDS are currently trading at about a 20% premium to Nifty, though historically they have traded at a discount,” the firm noted. Notably, given this view, UBS is underweight in the space in their portfolio positioning recommendation. “We advocate a bottom-up approach for our top ideas,” UBS said.

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