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Small and midcap (SMID) stocks have outperformed Nifty over the last 11 months. The outperformance versus Nifty is about to hit the cyclical historical peaks, DSP Mutual Fund said in a report.

Historically, small and midcap stocks enter a period of outperformance once they reverse from deep phases of underperformance, and perform poorly when they have high trailing outperformance. Currently, SMID stocks are not only trading with massive outperformance, but are also more expensive on a trailing basis.

Based on trailing 12M P/E ratio, the Nifty Index is trading at 21.8x, Nifty Midcap 100 Index is at 31x, while Nifty Smallcap 100 Index is at 23.5x. This opens the room for relative underperformance for small and midcap stocks, the report said.

Smaller firms can present a greater risk to investors looking for capital preservation. Historical data shows that a set of smallcap stocks with subpar fundamentals are eight times more likely to cause a permanent loss of capital to investors versus stocks from the quality bucket, the report said.

Quality is defined as companies with better ROEs, lower debt and lower variability of earnings. In fact, the Nifty Smallcap 250 Quality 50 Index has differentiated quality metrices. When a basket of ‘quality universe’ firms is compared to the broader universe ‘ex of quality’, the quality firms have nearly double the ROEs and less than 2/3rd debt.