The primary driver of the rally in small and mid caps appears to be irrational exuberance among investors, with high return expectations and purchase decisions being driven by the high returns of the past few months, Kotak Institutional Equities said in a report.
"We see limited point in trying to find fundamental reasons behind the steep increase in stock prices of several mid-cap and small-cap stocks," it said.
"In our view, the steep increase in stock prices simply reflects the irrational exuberance of investors in the mid-cap and small-cap parts of the market," it said.
"There is no meaningful change in the fundamentals of most companies; in fact, they have worsened in many cases," the report added.
"We do not see many fundamental reasons for the meteoric rise in the stock prices of many mid-cap and small-cap stocks in the past few months. The fundamentals of most sectors have not changed much. However, market sentiment is quite exuberant, based on steep increase in the prices of many mid-cap and small-cap. Stocks, large inflows into midcap and small-cap mutual funds and huge number of new retail participants in the mid-cap and small-cap," the report said.
The strong performance of the mid-cap. and small-cap. indices has possibly pushed up return expectations among retail investors.
Most of the traditional favorite mid-cap stocks of institutional investors in the broader 'consumption' sector have been large laggards in the ongoing mid-cap rally given weak consumption demand in general.
However, the valuations of these companies have stayed high or gone to historical-high levels due to earnings cuts.
Many of the new favorite mid-and-small-cap. stocks of institutional and retail investors are in the broader 'investment' sector (capital goods, defence, EMS, railways, real estate, renewables).
These stocks have delivered eye-popping returns in the past 3-6 months led by the broader 'investment' narrative.
"We expect a decent investment cycle, but we are not sure about the quality of many of the stocks given their historical weak execution and governance track-records. In addition, many of these sectors fall in the B2G (business-to-government) or B2B categories, which raises issues around execution and profitability both. We believe that market expectations for both revenues and profitability may be too optimistic across these sectors," the report said.
The last lot of the new favorite mid-and-small-cap stocks fall in the dubious category of 'turnaround' stories.
Many of these companies have been through serious operational and financial challenges (including bankruptcy) in the recent past, but the market has high hopes of these companies doing well in the future. We are not sure of the basis of the market's confidence, it added.
"We are dropping our recommended mid-cap portfolio since we cannot find too many stocks beyond the BFSI space that offer decent potential upside to our 12-month Fair value," it said.