Graphic: Mint
Graphic: Mint

Trapped in mid-cap stocks? What investors should do

Small and mid cap relative valuations suggest optimism may be priced in but not the uncertainties, despite the recent corrections

The rosy mid-caps bull story is pretty much over for now. So far this calendar year, the Nifty Midcap 100 index has shed 11%. On the other hand, the Nifty index (comprising of 50 large cap firms) has gone up 2.7%.

Its sharp outperformance earlier had resulted in soaring valuations for mid-caps and a correction was overdue. Ritesh Jain, chief investment officer at BNP Paribas Asset Management India Pvt. Ltd, said that mutual funds (MFs) had to rebalance their portfolio in keeping with Sebi (Securities and Exchange Board of India) norms, which defined categories such as large caps, mid caps and small caps.

“This put many mid-cap stocks out of favour with the MFs. Secondly, global liquidity has vanished from emerging markets," added Jain. A combination of these two accentuated the problem.

Nonetheless, valuations of mid caps are at a premium to their large cap peers. Have a look at Chart 1. Even as the one-year forward price-to-earnings ratio has declined for the Nifty Midcap 100 index, there is still a considerable gap when compared to the Nifty index.

This is also at a time when one-year forward earnings estimates for the mid-cap stocks had declined at a faster pace than that of large caps (Chart 2).

Small and mid cap relative valuations suggest optimism may be priced in but not the uncertainties, despite the recent corrections, pointed out UBS Securities India Pvt. Ltd in an investor conference report on 12 June.

What’s more, mid-cap profitability is expected to see some pressure in future due to high raw material costs. Higher crude prices would lead to an increase in crude-related input costs.

Relatively smaller firms may not have the pricing power to pass on higher costs to consumers. Plus, the Indian rupee is depreciating, adding to the insecurities.

Small and mid cap stocks have outperformed large caps during tightening periods, but have recently started to underperform, according to UBS.

“The economic growth cycle is less strong now than in historical tightening periods, and this is reflected in earnings cuts: we expect this to remain an overhang for SMIDs (small and mid caps)," said UBS.

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. But what makes mid caps a risky bet is the fact that when the market corrects, mid caps are likely to bleed the most.

So, what should investors in these stocks do?

“In the near term, we expect some bounce in mid-cap indices which could offer some selling opportunity," reckons Credit Suisse. In other words, investors can use market upmoves for some profit-booking in their mid-cap portfolio.

“We stick to our preference for large caps, which stands vindicated by a significant divergence between the performance of large and mid-cap indices YTD," added Credit Suisse.

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