Will the Smallcap Rally Continue?

2023 was a great year for smallcaps.

When the year was still fresh, the Smallcap to Sensex ratio was at 0.46 times, as compared to a long term median of 0.43 times, and previous peak of 0.58 time in January 2018, thus leaving a good runway potential for smallcaps.

Indian stock markets have touched a marketcap of US$ 4 trillion, well ahead of GDP.

But what about the Smallcap index?

The long-term median for Smallcap to Sensex is at 0.44 times. The index is way past that average. At 0.6 times, the Smallcap to Sensex ratio has already breached the previous peak of 0.58 in 2018.

From that peak in 2018, the smallcap index had crashed by more than 50%. It took three years for smallcaps to rebound to the same level.

If I go further in the history of past peaks and corrections, the Smallcap index had peaked in 2008, at a smallcap to Sensex ratio of 0.68 times.

The correction from 2008 peak was 79%, quite hard hitting. It took almost nine years post 2008 for smallcap index to come close to those levels.

So what would make the smallcaps correct this time?

For an answer to that, let's see what's fueling the interest in smallcaps.

As per AMFI data, for first 11 months of 2023, the inflow in smallcap funds has been crazy.

Rs 372 bn from the funds have found their way to smallcaps, as compared to an outflow of Rs 27 bn in largecaps and Rs 215 bn inflow in midcaps.

I'm not considering multi or flexicap funds for this, but the funds that are dedicated to large, mid and smallcaps schemes.

So, what do you think happens when a huge amount of money chases stocks with relatively low marketcap and liquidity?

Well, it's PE or price to earnings expansion. While earnings growth follows its course, the prices run ahead, leading to gains that are more in the speculative zone.

Little wonder then that a PE of 40 or above seems to be more of a norm now for smallcaps.

Smallcaps have limited capacity to absorb this kind of money. What's more, most of the funds are likely to be allocated towards a limited set of some of the well known smallcaps which have enough liquidity to absorb the fund flows.

This has led to a situation where the valuations of some of the liquid and well-known smallcaps have been pushed to perfection.

The growth prospects for the businesses in this set can barely justify the PEs they are enjoying. Any kind of negative surprise on earnings growth or external event that impacts fund flows is likely to have a disastrous impact on such stocks.

History has shown limited ability of even genius investors to predict such external events.

When the ability to predict is limited, one of the most sensible investment strategies is to be mindful of valuations and have a strong margin of safety in your buy price.

Caution, and not greed should be the dominating sentiment in the current rally.

While the institutional investors can't get enough of Indian stock markets, the insider activity has an entirely differently tale to tell. And it's scary.

Unlike tips that you come across on social media that could be just a front running exercise, promoter are invested in the business for the long haul.

Of all the entities tracking a particular stock, it is the insiders who know the most about the strengths, weaknesses and future potential of the business.

As such, keeping a track of what they do with the stocks of the companies they own could give you interesting insights about the business in your watchlist.

You see, the managements and promoters are never going to say that the stock of their company seems irrationally and expensively valued.

But when they do believe so, it's logical for them to make the most of the momentum and book some profits on shares they own. Of course, there could be multiple other reasons for insider selling.

But if you follow the trend of insider selling to insider buying regularly, interesting patterns and conclusions emerge.

In recent months, and for most part of 2023, the insider trades are more skewed towards selling than buying. It's definitely an eye-opening statistic.

Most of the companies are yet to declare the shareholding pattern for December. For September 2023 quarter, the number of stocks that have witnessed more than 5% decline in promoter holding is almost seven times the number of stocks with more than 5% increase in promoter holding.

What's more.... the insider selling in 2023 is at a multiyear high.

At Rs 1,108 bn, it is almost 2x of insider selling in 2020. And almost six times higher than 2018.

While promoters are selling heavily, guess who is lapping it up?

It's the retail investors and institutional investors.

Any shift in the sentiments or tightening of liquidity could lead to a sharp selloff in markets, especially in smallcaps.

So, while the rally in smallcaps could continue on high institutional interest and foreign buying and financialization of savings in the Indian economy, your buying decision and allocations should keep the possibility of a correction in mind.

Invest with margin of safety and with prudent allocations.

Warm regards,


Richa Agarwal
Editor and Research Analyst, Hidden Treasure
Equitymaster Agora Research Private Limited (Research Analyst)