The fall from glory for the mid-cap and small-cap stocks was quite swift. Punished for issues including lack of corporate governance (auditor resignations) and significant valuation premium over large-caps, mid-caps were beaten black and blue. The selling in small-caps accelerated after market regulator Securities and Exchange Board of India (Sebi) recently introduced additional surveillance measures on stocks.

Based on the shareholding data for the first quarter of FY19 for Nifty 500 companies, ICICI Securities Ltd estimates that foreign portfolio investors, mutual funds and insurance companies sold small-cap stock worth $1.1 billion during the first half of this calendar year.

However, these stocks now seem to be gradually finding their feet. Although the mid-cap and small-cap indices continue to underperform the benchmark on a year-to-date basis, they have recovered from this year’s lows. These indices have surged 7.6% and 8.3%,respectively, from then (see Chart 1).

But stock market analysts are not too convinced by this up move. In a scenario where key benchmark indices are regularly scaling new peaks, the rise in mid-cap and small-caps could be a rub-off. It may not necessarily mean that these stocks have suddenly found their lost charm.

Also, unlike earlier, these indices would not see a sharp surge from their current levels because their results are muted. The June quarter earnings, especially of small-caps, haven’t been very encouraging. In fact, some market analysts say small-caps are seeing higher number of earnings downgrades than their mid-cap and large-cap counterparts. Soaring input costs further dim the prospects of improved results in the forthcoming quarters.

No wonder then that earnings per share (EPS) estimates are falling. Bloomberg’s consensus EPS estimates for the Nifty 50 index have declined sharply from the start of this fiscal year. But EPS estimates for Nifty’s Midcap 100 index have seen the highest cut. The small-cap index has seen a relatively lower decline in estimates (see Chart 2).

Despite that, the valuation of mid-caps remains expensive. One-year forward price-to-earnings (P-E) multiple of the Nifty 50 index is 18.37 times, while the Nifty Midcap 100 is trading at 21.42 times. On the other hand, the Nifty Smallcap 100 is trading at a P-E multiple of 13.11 times.

In short, in the wake of the bleak earnings outlook, investors in mid-cap and small-cap stocks should tread with caution.

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