Decoded: Mutual funds, FIIs are net buyers, then why are small, midcaps bleeding (2024)

Small and midcap stocks have been in the line of fire since the start of this week, with many counters hitting the lower circuit as there are only sellers. The meltdown is happening even as domestic mutual funds and foreign institutional buyers have been net buyers.

Through this piece, we try to decode the factor that is causing this panic.

What has triggered this sell-off?

On February 28, the Association of Mutual Funds in India (AMFI) issued an advisory to its members, asking them to moderate inflows into small and midcap schemes and rebalance their portfolios.

The directive was at the behest of the Securities and Exchange Board of India (SEBI), which was worried about a froth building up in small and midcap stocks.

Are mutual funds selling mid and smallcap shares?

It is hard to say which category of stocks mutual funds are buying or selling. However, from February 28 till date, MFs have net bought around Rs 21,000 crore worth of shares.

What about FIIs?

They have net bought around Rs 20,000 crore worth of shares.

Then why are small and midcap stocks falling like nine pins?

Besides MFs, other categories of investors like high networth individuals (HNIs) and retail investors, too, have been direct buyers of stocks. Many of the HNIs had built up positions using borrowed funds. All of a sudden, liquidity in the system has dried up.

Also read: MF Stress Test: Why it matters and should investors be worried?

How did that happen?

Because of the year-end many investors started booking profits and cutting back on fresh purchases to balance their book of accounts. So, demand reduced. Secondly, the Reserve Bank of India (RBI) started coming down hard on non-banking finance companies (NBFCs), which were a major source of stock market funds.

What did the RBI do?

It asked IIFL Finance to stop disbursing gold loans till further notice. It barred JM Financing from lending against shares and financing IPOs and non-convertible debenture offerings.

But another unexpected development worsened an already bad situation.

What was that?

The Enforcement Directorate (ED) raided entities associated with Dubai-based alleged hawala operator Hari Shankar Tibrewala in the Mahadev Online Book illegal betting case.

Tibrewala was allegedly laundering proceeds from the betting racket by investing them in companies listed in India.

Why did that spoil the mood?

These entities had invested in preferential allotments of many companies through equity warrants. With their accounts frozen, they will not be able to pay the balance 75 percent amount at the end of 18 months.

Had they invested huge sums?

The stakes were not high but there are three issues.

One, the promoters of the companies that have received money from Tibrewala fronts are viewed as being close to the hawala operator.

Two, other HNI investors who put in money in these companies through preferential allotments are panicking, as they fear they, too, may be questioned by investigative agencies.

Three, it is not clear how many more front entities have invested in Indian companies besides the 13 whose accounts have been frozen by ED. It is a crisis of confidence right now.

The crisis of confidence is understandable but what about system liquidity?

It is tight because of year-end factors and is hurting HNIs and market operators who heavily rely on leverage.

Moneycontrol learns that many NBFCs are reviewing the list of shares that they are willing to lend against. Also, the generous overdraft facilities that HNIs have been enjoying so far are also being pared down.

Why are NBFCs doing that?

Because they want their books clean when the RBI inspects them. The talk in the market is that many NBFCs have been liberal in lending money against shares because the market has been rising over the last couple of years.

How does the NBFC move affect stock prices?

It has a domino effect.

When NBFCs cut back on overdraft facilities and refuse to lend against certain shares, HNIs and market operators will have to liquidate some of their positions. This will put pressure on those stocks. When the prices go down, other investors exposed to those stocks through borrowed funds will face margin calls from their lenders. This, in turn, will cause prices to go down further, setting off a vicious cycle of falling prices and more panic selling.

What next?

Money flowing through mutual fund SIPs is unlikely to drop off rapidly. Also, when valuations become attractive, many investors who had, so far, stayed away from the market may turn buyers.

Companies that are perceived as tainted due to association with dubious entities may take longer to recover even when sentiment and liquidity improves. In the case of fundamentally strong stocks, the recovery will be sharper.