Mumbai: Midcap stocks that led the recent markets rally have started falling as investors grow cautious over high valuations.

The BSE Midcap index slipped 1.17% in May, despite a 21.56% rise in 2017. The BSE Smallcap index fell 1.9% in same period after a 25.19% jump in the year so far.

At current levels, BSE Midcap is 497.48 points away while BSE Smallcap is 669.82 points off life highs touched earlier in the month.

In contrast, the benchmark BSE Sensex has risen 4.1% in May, after gaining 16.97% in 2017. Of the 85 stocks in the BSE Midcap index, 53 were in the red in the one-month period to 31 May 2017.

Among the major laggards, Reliance Communications Ltd plunged 42.03%, Glenmark Pharmaceuticals Ltd 28.70%, Reliance Infrastructure Ltd 19.86%, IDBI Bank Ltd 23.19%, Bank of India 24.04%, Torrent Power 16.07%, Reliance Capital Ltd 15.57% and Reliance Power Ltd 15.63% in the month ending 31 May.

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Analysts said midcap stocks were running ahead of time and valuations were turning expensive.

Karthikraj Lakshmanan, senior fund manager-equities, BNP Paribas Mutual Fund said, “After correction, deserving companies which have strong fundamentals will see a bounce-back on firm earnings growth." At current levels, valuations of mid and smallcap indices are still expensive with one-year price-to-earnings (PE) ratio at 19.67 and 19.72 respectively, whereas it is 18.73 for the Sensex and 18.19 for the Nifty.

Vinod Nair, head of research at Geojit Financial Services said valuation-wise, the gap between mid and smallcaps was increasing due to the high liquidity that was flowing into the markets in April and May.

Another reason he cited for the midcap sell-off in the past one month is the impending rollout of goods and services tax (GST).

“GST rates for consumer durables like electronic goods are set at 28% which is higher than the present 17-18% and is going to pinch companies especially the smaller ones in the sector. It will be difficult for the smaller consumer durables companies to increase price, which means they may have to bear it," he said.

Yashas Bhat, an analyst at LKP Securities Ltd agreed that smaller companies may be hurt due to GST compliance rules. “Small and mid-companies may take time to become GST ready and consequently demand may be hit."

He further said cautious investors were booking profits in midcaps due to GST concerns and high valuations as a combination of optimism and liquidity were driving these stocks.

However, both the mid and smallcap indices have beaten benchmark indices in three- and five-year performance.

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BSE Midcap jumped 72.73%, BSE Smallcap gained 69.77%, while the Nifty climbed 33.07% and Sensex rose 28.61% in the three year period ending 31 May.

In the five-year period from 2012 to 2017, BSE Midcap gained 147.55%, BSE Smallcap rose 135.45% while Nifty and Sensex were up 95.39% and 92.04% respectively.

According to Sunil Sharma, chief investment officer at Sanctum Wealth Management, midcaps will continue to deliver strong earnings growth and are well-positioned to deliver higher earnings growth relative to large caps. “Roughly 60% of the CNX 500 that has reported to date has met or beaten expectations. Further, we’re seeing top line growth coming through and in a departure from prior quarters, operating leverage has been somewhat disappointing," he added.

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