Mid-caps were in top form throughout 2016. On a year-to-date basis, the BSE MidCap Index has beaten the Sensex for the third consecutive year. That’s not all—it has given better returns than all the sector indices, except oil and gas and metals. On the valuations front, too, the BSE MidCap Index is trading at a one-year forward price-to-earnings (PE) of 18.79 times, which is higher than that of Sensex and many other sectoral indices.

This outperformance can largely be attributed to the weight of local money flowing into Indian equities, partially in the belief of an imminent economic recovery and partly because alternative avenues for parking funds such as real estate are depressed. Generally, when key indices rise, mid-caps tend to rise faster and are driven by investments of market participants who may have missed the rally earlier. Mutual fund managers chasing handsome returns also parked funds in this space since large-caps didn’t do all that well, said some analysts.

The key question is whether the mid-caps will continue to remain a favourite in 2017, too. Much depends on the outcome of what has become the defining event of 2016 for the domestic economy—demonetization. The after-effects of demonetization, how the government proposes to counter some of the ill-effects in its budget, the progress of the much-awaited and much-delayed goods and services tax (GST) and, perhaps, the outcome of the Uttar Pradesh election will be key triggers.

“Mid-caps are likely to continue their outperformance, at least until the budget, and key benchmark indices will be range-bound; post that, the latter will catch up. Only those mid-caps which will be the actual beneficiaries of demonetization and GST will continue their outperformance. Post demonetization, many quality large-cap stocks have corrected and are available at reasonable valuations. Investors can consider investing in them, instead of mid-caps," Sanjiv Bhasin, executive vice-president-markets at IIFL, said.

Moreover, mid-caps are by no means cheap. Some mid-cap stocks with high valuations are Adani Power, Indian Hotels, United Breweries, GlaxoSmithKline Pharma, Blue Dart, which trade at 380, 123, 61.85, 54.8, 54.5 times one-year forward PE, respectively.

But the charm of the mid-caps is that, chosen right, their returns can be mouth-watering. So far in 2016, the best performers in the mid-cap space, when it comes to stock market gains, are Indian Bank, which surged 102%; Biocon (91%); Piramal Enterprises (70%); National Aluminium (64%) and HPCL (60%). Of the 84 stocks in the BSE MidCap Index, 48 have posted gains so far this year, while of the 780 stocks in the BSE Small-Cap index, 368 are in the green so far.

What makes mid-caps a risky bet is not just the challenge to pick quality stocks that are liquid and valued reasonably, but also the fact that when the market corrects, mid-caps are likely to bleed the most.

And the valuations at which the mid-cap stocks are currently trading makes analysts cautious about them.

“We still think it is early to revisit mid-cap stocks as they have not corrected sufficiently. We had stopped recommending mid-cap stocks from August 2016 as we found the valuations of such stocks quite frothy in general at that time. Valuations have corrected in several cases but we still cannot find too much value in the mid-cap stocks, barring the real estate sector," a recent Kotak Institutional Equities report said.

Sharing a similar view, Morgan Stanley, in its 2017 equities outlook report, said Indian equities are once again looking attractive and are poised for double-digit returns in 2017, but mid-cap valuations are one of the key risks.

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