We wrote last week that smaller firms have had it far rougher than their bigger counterparts since demonetization. The recently concluded June quarter earnings were also badly hit by the transition to the goods and services tax (GST).

Interestingly, mid-cap stocks have continued to outperform their larger peers. What’s more, valuations for both are almost at par, as Chart 1 below shows. Twelve-month forward price-to-earnings ratios for both mid-cap and large-cap companies in Edelweiss Securities Ltd’s coverage are currently pretty much at the same level. But this is at a time when the earnings of mid-cap companies have not kept pace with that of large-caps.

Chart 2 shows revenue growth for both mid-caps and large-caps has slowed down in recent quarters. The weakness in earnings of mid-cap companies, however, is much more pronounced than that of the larger ones. According to Edelweiss, PAT (profit after tax) growth for mid-cap companies excluding commodities during the June quarter declined as much as 30% year-on-year, based on the two- quarter moving average. The measure for the March quarter was 20% lower compared to the year-ago period.

The sample considered for this analysis is Edelweiss’s coverage universe (excluding commodities) of 187 firms. Within that, 79 are large-cap companies and the remaining are mid-caps. For the purpose of this study, mid-cap companies are those with a market capitalization of less than $3 billion whereas the rest are considered large-cap.

Interestingly, mid-cap valuations haven’t corrected despite a sharp fall in earnings.

According to Sanjiv Bhasin, executive vice-president (markets and corporate affairs) at India Infoline Ltd, “Mid-caps are extremely expensive at the current levels." This is a bubble created by liquidity and the feel-good factor, as mutual funds try to get more growth by chasing mid-caps after having missed the earlier rally in the large-cap companies, added Bhasin.

“Sure, price-to-earnings multiples for mid-cap companies should be lower than that of large-caps in keeping with liquidity risks and historical averages," says Dhananjay Sinha, head of research at Emkay Global Financial Services Ltd. However, multiples are also a function of liquidity and as long as liquidity persists, the distortion will continue, pointed out Sinha, according to whom the bigger question to ask is whether the inflows into equities will continue.

The signs for a mid-cap correction are all there. Delayed demand revival, elevated raw material prices and the exact impact of GST on companies’ balance sheets are key things to watch out for.

“If a correction happens, then mid-caps are likely to fall at a much sharper pace than the broader markets," cautioned Bhasin.