Mumbai: With the BSE MidCap index seeing a sharp fall this year, its valuation premium over larger set of stocks is shrinking at a rapid pace. From beginning of this fiscal, the premium of BSE MidCap index to Sensex has slipped 65.11% to current levels from the highs it had touched on 3 September.

At current levels, one-year forward price-to-earnings (PE) ratio of the BSE MidCap index is at 20.55, while the Sensex is available at 18.96, according to Bloomberg. On 3 September, when the premium of BSE MidCap over Sensex was highest for this fiscal, the PEs were at 24.80 and 20.47, respectively. Similarly, the premium between BSE SmallCap index and Sensex has fallen to -1.8% at the current level.

While BSE MidCap and BSE SmallCap have slipped 20.25% and 25.79%, respectively, the Sensex rose 2.12% during the period.

Analysts feel that valuations between both BSE MidCap and Sensex will soon converge, indicating that downside in mid-cap stocks is not capped at the current levels.

“Historically, mid-caps have outperformed the Sensex and always had a premium. However, due to multiple factors, mid-caps are slipping and with more earnings downgrade, mid-caps valuation may fall (further)," said Rusmik Oza, senior vice president and head of fundamental research, Kotak Securities.

Oza expects more earnings downgrade after the September quarter following the margin shrinkage because of high crude prices and rupee depreciation.

Sensex’s expected earnings for the current fiscal and the next FY20 have been slashed by 1.4% and 0.4%, respectively, since the beginning of FY19, according to Bloomberg estimates. For BSE MidCap, earnings for FY19 and FY20 have been downgraded by 8.7% and 7.8%, respectively.

Oza said there could be redemption pressure in Portfolio Management Service after the recent market performance, which may lead to further loss in mid-cap stocks as the PMS portfolio is mostly concentrated on mid- and small-caps.

Oza also said that the liquidity crunch is impacting both mid- and small-cap stocks. “Last year, liquidity was easily available, which led to re-rating of these stocks. Liquidity crunch now post-ILFS crisis is squeezing mid- and small-cap stocks and may see price target reductions soon," Oza said.

Once expensive, valuations of both BSE MidCap and Sensex have become fair after the major correction, said analysts. Earnings growth may be slower but valuations of the stocks appear reasonable said Pankaj Pandey, research head at ICICI Securities.

“Valuations of both MidCap and Sensex are fair at the moment, but not everything in the index will look attractive. There is a decent amount of growth visibility in selected stocks in both mid and large caps as not all companies will be impacted by crude and rupee. In Q2, we expect 18% growth in topline and 11% increase in bottomline for stocks in our coverage, which is typically equally divided between large, mid and smallcap," he said.

Pandey thinks that there could be more volatility in markets, especially in mid-cap stocks as there is fear in the markets because of uncertainties. “Investors are worried about global developments and domestically ahead of the crucial elections in the next 5-6 months while RBI is also expected to hike interest rates which will increase borrowing costs for companies. Another reason is due to the NBFCs crisis and liquidity crunch which may take sometime to be resolved," Pandey said.

Meanwhile, share of both BSE MidCap and BSE SmallCap in overall market capitalization has decreased while that of Sensex has grown. At current levels, the BSE MidCap index contributes 13.67% to India’s market cap, down from 14.38% in April 2018 and 14.16% in beginning of this year. In contrast, contribution of Sensex to India’s total market cap has grown to 45.36% at current levels from 39.68% in April. The increase in the large-cap stocks indicates that investors are shifting out of riskier segments as large caps are not very vulnerable to volatility as smaller stocks.

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