In the Netflix thriller Squid Game, a group of people sign up to play and win a fortune, only to find themselves trapped in a bloodbath. A similar game may be unfolding in India’s small- and mid-cap stocks space, where investors who bet on instant riches may struggle to exit free-falling low-float stocks.
Blinded by the returns of previous years, small investors rushed headlong into these stocks directly and through equity schemes, ignoring warnings from the market regulator. Prices and valuations soared, particularly of stocks with inadequate “free float”—the portion of shares available for public trading. Even after a steep fall, their valuations remain high, and if the slide continues as expected, investors may find themselves trapped in illiquidity, watching their fortunes fade.
The Securities and Exchange Board of India (Sebi) had mandated fund houses to conduct regular stress tests—assessments of liquidity and risk parameters. This led to a notable market adjustment in the December quarter, as both domestic institutions and individual investors reduced their stakes in illiquid, low-float equities. For those remaining, the risks may be higher now.
“Over the past two quarters (Q1 and Q2), we saw some run-up in low-float mid- and small-cap stocks. This lured many retail investors but many have now seen sharp corrections. The risk is not off the table yet,” said Nirav Karkera, head of research at Fisdom, a digital wealth management platform.
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Anand K. Rathi, co-founder of investment platform MIRA Money, echoed similar concerns. “Free float has always been a concern, especially for small-caps more than mid-caps, and this issue becomes even more critical in sharply falling markets like the one we’re witnessing today,” he said. “We foresee that the mid and small-cap space could correct another 10-15%, which means many retail investors—who haven’t been able to exit due to lower free float—might end up stuck with these stocks for an extended period. Some of these companies could turn out to be duds as well.”
Here are some grim facts. 56% of mid-caps and 73% of small-caps have plummeted over 30% from their 52-week highs. Four-fifths of mid-caps that saw a median run-up to 31% in six months through September, when markets peaked, and 70% of small-caps that surged up to 25%, shared a fatal flaw: inadequate free float.
Some analysts also warned that fund houses with inadequate entry and exit strategies could face severe liquidity challenges.
“Fund houses who have not been following a staggering entry and exit policy are going to face extreme liquidity risks in the future, especially the ones focusing on small- and mid-cap space, unless domestic institutional investors (DIIs) strengthen themselves and take advantage of the low valuation that we are witnessing with this market correction,” noted Anchal Kansal, a research analyst at Green Portfolio, a portfolio management services firm.
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Even more disturbing, among the low-float mid caps that have cratered by over 30%, retail investors are the dominant shareholders after promoters in 57% of companies. In the small-cap realm, this figure jumps to 77%. This seems to create a disproportionate burden on retail investors, leaving them vulnerable compared to domestic institutional players.
Retail investors’ exposure to low-float stocks makes them more vulnerable in the event of a further market decline, Karkera of Fisdom pointed out.
“On the other hand, domestic institutional players such as mutual funds have largely steered clear of these stocks. Their portfolios remain highly liquid, so a liquidity crisis is unlikely to be a significant concern for them,” he added.
Rathi of MIRA Money suggests investors exit before reaching a point of no return. “If you’re getting an opportunity to exit a low-quality company, even at the current price, it’s worth considering.” “We believe the correction could persist for some time, and holding an illiquid stock might mean being stuck for a very long period before any meaningful volumes return. So, investors should be extremely cautious and avoid overexposure to illiquid mid- and small-cap companies,” he said.
Despite such steep corrections, 71% small-caps and 54% midcaps are still trading at a premium to their historical price-to-earnings ratio. “I would say the correction so far has been healthy, but it is not a screaming bottoming-out situation. So, we need to be very selective with plays within the mid and small-cap, Karkera added.
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Talking about high valuations, Anand Vardarajan, chief business officer at Tata Mutual Fund, advises investors to adopt a long-term approach. “The entry point plays a key role—investing at high valuations could mean a longer wait for meaningful returns, regardless of the asset class. Ultimately, understanding the price you pay and the underlying valuation is essential.”
