An $80 billion crash in smallcaps flashes warning signs

As sentiment weakens, investors are pulling money out of richly valued larger shares as well. The MSCI India Index is now lagging behind MSCI’s Asia Pacific index for a second straight month, with markets such as Taiwan and South Korea more in favor due to their exposure to chip shares and the artificial-intelligence boom. Some investors anticipate losses will deepen.

“The regulatory actions against small cap stocks are testimony to the valuation froth in India,” said Nitin Chanduka, a strategist at Bloomberg Intelligence. “India could continue to underperform Asia going into the national elections in the next few weeks and amid the chip rally in other markets in the region.”

Bloomberg

The Securities and Exchange Board of India has been concerned about large flows into small- and mid-cap stocks amid an outsized rally in the riskiest area of the nation’s $4.3 trillion market over the past year. Late last month, it asked funds to come up with measures to moderate inflows into related plans and safeguard investors from sudden redemptions.

“It may not be appropriate to allow bubbles to keep building because when they burst, they impact investors adversely,” Chairwoman Madhabi Puri Buch said earlier this week. Sebi is open to allowing money managers to hold more large-cap stocks in their small-cap portfolio to manage risk, she said.

Buch further said the regulator has observed “patterns of price manipulation” in new listings taking place on platforms for tiny companies. The souring mood is affecting debuts in India this week, with the three latest initial public offerings declining as much as 16% in their first trading days versus an average gain of 20% this year through Wednesday.

In light of the regulator’s remarks, ICICI Prudential Asset Management Co. on Tuesday said it will temporarily halt lump-sum deposits in its mid and small-cap funds starting Thursday. Last month, Kotak Asset imposed limits on flows on recurring plans in its small-cap fund, citing the sharp surge in this segment that has led to “valuation distortions” in some cases.

The S&P BSE Small Cap Index is down more than 12% from an all-time high reached earlier this year. Some investors used the declines to load up on shares as market participants overall remain bullish on Indian equities. Domestic institutional investors including mutual funds and insurance companies plowed a record $1.1 billion into local shares on Wednesday, exchange data showed.

Smaller stocks led the record-breaking rally in the Indian equity market in the past year, which forced foreign funds to look beyond the typical large cap names. But it also may mean that there’s more downside potential.

“This space was too hot and the correction may not be completed in a hurry,” said Porinju Veliyath, founder and portfolio manager at Equity Intelligence Pvt. Ltd. “There is still a lot of froth in many pockets,” he said, adding that the slump may provide investors an entry point into quality stocks.