Mumbai: Mid-cap and small-cap indices of the Bombay Stock Exchange (BSE) have underperformed the Sensex by 8.78% and 12.68%, since the Fed rate cut on 18 September.
BSE benchmark index Sensex rose 23.11% during this time, while mid-cap index rose 14.33% and small-cap index rose 10.42%. This isn’t surprising as much of the action has been concentrated on a few large stocks. Even within the Sensex, it’s a few large stocks that have led the bull rally.
BSE defines small-cap shares as those that form the bottom 5% of the exchange’s listed firms in terms of market capitalization. Mid-cap index comprises stocks that fall between the bottom 5% and 20%.
Fundamentally, there’s no reason for mid-caps and small-caps to underperform. In fact, their superior earnings growth should result in comparative outperformance. In the September quarter, the non-oil and non-bank companies forming the mid-cap index grew operating profit by 24.5%.
Small-caps weren’t far behind, growing their core earnings by 24.4% last quarter. This is better than the 19% growth reported by the firms forming the Sensex. Net profit growth, however, was slightly higher in the case of Sensex firms, data collected from Capitaline Databases shows. This could be due to the higher proportion of other income in the case of most large-cap companies.
Nevertheless, it’s important to note that the underperformance since 18 September has led to a considerable increase in the valuation differential of mid-caps.
In September, BSE’s mid-cap index traded at a discount of about 8.7% to the Sensex. The discount has now nearly doubled to 16.5%. For small-caps, the discount has increased from 25.4% to 35.7% in the same period.
In a recent note, HSBC Global Research advises its clients to prefer mid-cap stocks for investment in Indian equity markets. The reason is that though mid-cap earnings growth is expected to be significantly higher in the next three years, their valuations are much lower.
Consensus estimates quoted in the HSBC note suggest that mid-cap earnings will grow at a compounded annual growth rate of 34%, compared with a growth of 24.2% for large caps.
The one-year forward price-earnings multiple of mid-cap firms is 14.8 times—about 22% lower compared to large-caps. HSBC defines mid-caps as stocks with a market cap of between $500 million (Rs1,965 crore) and $ 1billion.
Small-cap companies, too, are estimated to grow earnings at a higher compounded growth rate of 33.8%. But one would have to be stock specific while investing in mid- and small-caps. And investors would be well advised to stay away from penny stocks.
Although mid- and small-cap companies are growing at a faster rate owing to a low base, that doesn’t necessarily mean that the smallest in the rung are growing the fastest.
A Mint analysis of companies with a market cap of less than Rs100 crore reveals that their core earnings fell 23% in the last quarter. Worse still, they didn’t have the benefit of higher other income, but were instead hit because of higher interest and depreciation charges. As a result, their net profit fell by as much as 85%. In the June quarter, their profit had fallen 68%.