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Mumbai: The valuation of mid-cap stocks is at its highest since early 2008, when Indian markets were at their peak, and tumbled soon after. With BSE mid-cap and small-cap indices touching a record close on Monday, it is time investors exercised some caution.

According to data from Bloomberg, BSE mid-cap index was trading at 33.12 times one-year forward price-to-earnings (P-E) as on 25 July, the valuation last seen in January 2008, when the market was inching to new highs.

BSE small-cap index was trading at 65.87 times one-year forward P-E as on 25 July, last seen in September 2015. Meanwhile, BSE’s benchmark equity index Sensex was trading at 17.48 times one-year forward P-E on the same day, its highest since 31 March.

Wealth managers and dealers say that it is increasingly getting difficult to pick up quality stocks at attractive prices in this space. Also, rumours about these counters in a bull market lure less-informed investors to low-quality and low-potential stocks at irrationally high prices. A retail investor, who is typically a late entrant in a bull market, looks to make quick money. Such investors could eventually erode their wealth, as these scrips turn illiquid later.

“There is no doubt that a sense of exuberance has crept into a section of mid- and small-caps, due to large liquidity chasing a section of the market, for quick and huge gains," said Ajay Bodke, chief executive officer (CEO) and chief portfolio manager, portfolio management services, at securities house Prabhudas Lilladher Pvt. Ltd.

Bodke pointed out that there are large inflows in the small- and mid-cap space. “Typically, you stop taking large cash calls, when inflows are coming in these funds, and fund managers are forced to allocate money in these scrips," said Bodke.

Apparently, it becomes a vicious circle, and this goes on until the fervor of investors to invest in mid- and small-cap continues, and returns are progressively rising.

In the mid-cap space, the companies with highest one-year forward earnings ratio as on Monday are Alstom T&D India Ltd, ABB India Ltd, 3M India Ltd, GlaxoSmithKline Pharmaceuticals Ltd and Blue Dart Express Ltd, trading at 119.69 times, 91.66 times, 82.18 times, 76.51 times and 73.66 times, one-year forward earnings, respectively, data from Bloomberg showed.

So far in 2016, the best performers in the mid-cap space, when it comes to stock market gains, are Yes Bank Ltd, Piramal Enterprises Ltd, JSW Steel Ltd, Biocon Ltd and Bajaj Finance Ltd, gaining 64.43%, 61.25%, 58.41%, 57.81% and 49.85%, respectively.

Of the 82 stocks in the BSE mid-cap index, 52 have posted gains so far in the year, while of the 761 stocks in the BSE small-cap index, 363 are in the green so far.

Companies with highest stock price gains so far in 2016 in the small-cap space are Tata Metaliks Ltd, Kiri Industries Ltd, Shilpi Cable Technologies Ltd, Sudarshan Chemical Industries Ltd and Manappuram Finance Ltd. They rose 353.72%, 244.64%, 196.75%, 180.65% and 164.38%, respectively.

Investors need to keep a close watch on the earnings and other developments about the mid- and small-cap stocks in their portfolio.

“The reality check should come from current earnings, and the outlook that these companies predict over the medium term. Investors need to be vigilant of the current developments in the stock, and watch out for irrational price movements in the counters," added Bodke.

There is a risk that liquidity can dry up for these scrips in a matter of few sessions, and one can get stuck with investment in these counters. Some of these stocks tend to jump very fast on thin volumes. It is not unheard of that low quality stocks, tend to join the party and post humongous stock price returns, purely based on expectations, which may or may not have the potential to materialize.

That is where the problem kicks in.

“It is great to enjoy the ride up, however when liquidity dries up and earnings don’t measure up to lofty expectations, the end result is massive plunge is stock price and tremendous erosion of investor wealth," said Bodke, adding that it was getting increasingly difficult to pick stocks at attractive valuations in this space.

“It obviously is not going to be easy to cherry pick stocks in this space, and the variation of profitability and growth in these sectors in this area is very large," said Rakesh Rawal, CEO of private wealth management at Anand Rathi Financial Services Ltd.

According to Rawal, though there is going to be a lot of opportunity, investors have to be very careful. “Growth is not going to be everywhere choosing the right stocks is going to be very difficult," Rawal said, adding that one has to look at individual stocks rather than sector-specific bets.

“It has to be the bottom up approach (for selecting stocks). The top down approach does not work in this kind of a market," added Rawal.

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