Kotak Institutional withdraws mid-cap portfolio recommendations citing ‘irrational exuberance’

Leading Indian brokerage firm Kotak Institutional Equities has sounded the alarm on the recent rally in mid- and small-cap stocks, warning clients that the sharp increase reflects “irrational exuberance” among investors rather than fundamentals. As a result, Kotak has dropped its recommended mid-cap portfolio, saying it could not justify recommending stocks trading significantly above fair value estimates.

“There is no meaningful change in the fundamentals of most companies; in fact, they have worsened in many cases,” said Kotak analysts, adding that they don’t see much of a point in trying to find fundamental reasons behind the steep increase in stock prices of several mid-cap and small-cap stocks.

“The primary driver of the rally 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,” the report, authored by Sanjeev Prasad, Anindya Bhowmik and Sunita Baldawa noted.


In August 2022, the Nifty Midcap 100 rallied 6.7% compared to the Nifty 50’s 4.1% gain. The Nifty Smallcap 100 index increased by an impressive 9.6% last month.

Over the past year, India’s mid- and small-cap indices have significantly outperformed the benchmark Nifty 50 index. The Nifty Midcap 100 index has gained 10.5% compared to just 0.9% for the Nifty 50. The outperformance is even more stark in the small-cap space, with the Nifty Smallcap 100 index surging 34.5% over the same period.

The Kotak Ins report points to several signs of overly exuberant sentiment, including steep increase in the prices of many mid-cap and small-cap stocks and large inflows into mid-cap and small-cap mutual funds.

“The strong performance of the mid-cap and small-cap indices has possibly pushed up return expectations among retail investors,” it noted,

Kotak takes particular aim at traditional mid-cap “consumption” stocks, arguing their valuations remain high despite weakening fundamentals. “We see risks of (1) lower profitability and (2) lower valuation multiples due to weakening business models (erosion of business moats of brand, distribution market structure and product),” the report states.

At the same time, Kotak cautions that many of the new mid- and small-cap darlings may also disappoint. The report notes that while many of these companies are in ‘investment’-related sectors like capital goods and real estate that could benefit from an investment cycle, “we are not sure about the quality of many of the stocks given their historical weak execution and governance track-records.”

“We believe that market expectations for both revenues and profitability may be too optimistic across these sectors,” Kotak concludes.

No Special Skills

In an apparent dig at the market, the analysts confessed to have developed ‘no special stock-picking skills’ that they can use in the current environment of irrational exuberance, and said it was removing all mid-cap stock recommendations from its model portfolio.

“Many of the stocks have jumped in the past few months (some within weeks of inclusion in the portfolio). We have changed the portfolio frequently in the past few months to keep up with rampant stock prices, but have largely run out of options now. It is obvious that we have not developed some special stock-picking skills recently,” they noted.

It, therefore, said it was dropping the recommended mid-cap portfolio since it cannot find too many stocks beyond the BFSI space that offer decent potential upside.

“Most of the non-BFSI stocks are trading above at around our 12-month Fair Values. The valuations of stocks in our favorite capital goods, healthcare, QSR and real estate sectors discount growth for the next few years and leave absolutely no room for any disappointment.

“We would have had to remove these stocks from the portfolio anyway, as it would be incorrect to recommend stocks with low conviction and potential downside to our Fair Values, which would have left a portfolio comprising BFSI stocks largely,” it noted.

What Others Say

Overall, analysts remain selectively positive on mid-caps and small-caps due to attractive valuations versus historical averages, earnings momentum, and improving macro environment.

Brokerage firm Motilal Oswal notes that mid-caps and small-caps generally tend to do well when earnings momentum picks up at the start of an economic recovery. It believes their valuations are reasonable now after the sharp underperformance versus large-caps seen over the past three years.

ICICI Securities highlights that mid-caps have seen strong earnings upgrades of late, with Q1FY24 results showing 39% earnings growth versus 33% for Nifty companies.

Analysts also point to the steady improvement in domestic economic activity as a driver of the small-cap resurgence.

Ambit Capital believes that a pick-up in bank lending, revival in private capex, and continuing strength in consumption provide a conducive backdrop.

Credit Suisse expects a broad-based earnings recovery to support small-cap performance over the next 2 years.

However, some brokerages have struck a note of caution amidst the euphoria.

JM Financial notes that small-caps rallied strongly in the past when market liquidity was abundant, but rising rates could impact liquidity going forward.

Citi points out that small-caps still trade at a premium to large-caps despite the underperformance. It suggests some profit booking may be warranted at current levels.