Kotak Institutional Investors has dropped recommendation on the mid-cap space as it cannot see too many options beyond the BFSI space that offer decent potential upside from their fair value.

There are limited points in trying to find fundamental reasons behind the steep increase in stock prices of several mid- and small-cap stocks with no meaningful changes in the fundamentals of most companies and, in fact, they have worsened in many cases.

The research firm said it has removed favourite stocks in capital goods, healthcare, QSR and real estate sectors from the portfolio as it would be incorrect to recommend stocks with low conviction and potential downside to fair values.

“We have changed the portfolio frequently in the past few months to keep pace 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. In our view, the steep increase in stock prices simply reflects the irrational exuberance of investors in the mid- and small-cap space,” it said.

Pratik Gupta, CEO, Kotak Institutional Equities said it has been a liquidity-driven rally and investors should tread cautiously in the market as valuations are expensive now with the Nifty 50 trading at a FY2025 P/E ratio of over 18 times, which is not cheap and small/mid-caps are even more expensive in many cases.

The primary driver of the rally appears to be irrational exuberance among investors, with high return expectations being driven by past experience, it added.

No fundamental reasons

The meteoric rise in many mid-cap stocks is not backed by any fundamental reasons and the market rally is driven by large inflows in small- and mid-cap mutual fund schemes and jump in number of new retail investors participation as the indices of these sectors have hit a new high.

Interestingly, most traditional favourite mid-cap stocks of institutional investors in the broader ‘consumption’ sector have been large laggards in the ongoing mid-cap rally, given the weak consumption demand. However, the valuations of these companies have stayed high or gone to historical-high levels.

Stocks in capital goods, defense, electronic manufacturing services, railways, real estate and renewables have delivered eye-popping returns in the past 3-6 months despite concerns about the quality of these stocks, given their historically weak execution and governance track-records.

In addition, it said many of these sectors fall in business-to-government or B2B categories, which raises issues around execution and profitability, it said.

The last lot of the new favourite in mid-and-small-cap stocks is the dubious category of ‘turnaround’ stories. Many of these companies have been through financial challenges including bankruptcy in the recent past, but the market has high hopes for these companies doing well in the future, said the report.