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The sharp outperformance of small and midcaps in 2023 has led to valuations becoming a challenge now, foreign brokerage Jefferies said in a report.

At 27x 1-year fwd PE, the Nifty Midcap100 index trades at 35 per cent premium to its average valuations, vs a less than 20 per cent premium for the Nifty 50.

"This makes the SMIDs susceptible to a sharp sell-off. We believe that the Budget/approaching elections may disappoint on govternment capex, creating a possible trigger for sell-off in parts of the SMID universe, particularly among industrials, select PSUs etc.," the report said.

After a 25-35 percentage point outperformance by mid/smallcap indices, 2024 could start with a bias rotation towards larger caps.

A reason for SMID outperformance has been the lack of capex plays among the largecaps.

SMID caps offer a bunch of options to play the industrial recovery. Early rotation signs in December has seen largecaps outperforming midcaps. Positioning in financials is light with domestic OWT near multi-year lows. A potential budget disappointment on capex could cause a sector rotation early in 2024, the report said.

The domestic capex cycle recovery is a key theme driving SMID cap outperformance.

The capex plays are important portfolio weights for the medium to long-term investors. However, there is a dearth of such ideas among largecaps with only three Nifty-50 components/5 per cent market cap belonging to this direct capex play (industrial & realty) group.

However, 18-20 per cent of SMID market cap is spread over the industrial and realty companies, necessitating the reach among the lower midcap names to play the cyclical story, the report said