Low free float and a strong narrative expecting high potential returns, among other factors, are likely drivers behind the exceptional performance of the mid- and small-cap stocks, according to Kotak Institutional Equities
The rally can be attributed to improved fundamentals in a few cases, but strong narrative in many cases, the brokerage said in an Oct. 30 note. Many low free float stocks have seen a sharp surge in delivery volumes, which may reflect the market's heightened expectations, it said.
Nifty SmallCap 100 and Midcap 100 have surged 30% and 23% year to date, respectively, compared with a 5% rise in benchmark Nifty 50. Ongoing volatility has stalled the rally for now, with market veterans calling a clean-up of valuation excesses.
Low Free Float
The top quartile of outperforming companies have lower free floats--the proportion of available for trading--than their underperforming counterparts, Kotak said. That suggests free float may have created a sense of scarcity, driving up demand for these stocks.
The brokerage attributed sharp increase in delivery volumes to increasing expectations of strong returns from the small- and mid-cap space, as reflected in increased inflows in small- and mid-cap mutual funds.
Historical Parallels
The Kotak report draws a parallel with the mid-cap rally of 2017. Back then, stocks with lower free floats, too, outperformed their peers. However, the report refrains from drawing conclusions based on the historical trend.
Narratives Must Translate To Reality
The report cautions that market expectations may have become overly optimistic, with stock returns outpacing improvements in the fundamentals of many mid- and small-cap companies. "Recent price corrections have signaled the market's nervousness about these lofty valuations," it said.
For the recent strong stock performance to be sustained, the outperforming companies may need to demonstrate significant improvements in their financial and operating performance, the report said. It highlights the need for these promising narratives to translate into reality.
For stocks to maintain their momentum, the report said, they must transform their narratives into concrete financial and operational success.
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