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Home / Markets / Mark To Market /  Big hopes ride on small caps, but the road ahead is risky

Mid-cap and small-cap stocks stole the thunder from large companies in 2021. The Nifty100 Midcap and Nifty100 Smallcap indices surged 46% and 60%, respectively, widely outperforming the Nifty50 index’s 24% gain.

Mid-cap and small-cap stocks tend to perform well during periods of economic revival. But, towards the fag end of 2021, the discovery of the Omicron variant has renewed worries on economic growth. Nevertheless, Dalal Street participants are upbeat on listed mid- and small-cap stocks and this optimism is well captured in the FY23 earnings growth expectations. “The Street has built robust earnings growth (+44%/+34%) for mid-/small-caps vs large-caps (+18%) for FY23," BofA Securities pointed out in a note to clients.

Flying high
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Flying high

These estimates appear aggressive against the backdrop of economic activity losing steam. Moreover, companies across the board have been battling severe operating cost pressures in the past few quarters. While broadly, many companies have taken price hikes, the impact of the steep input cost inflation on mid-cap and small-cap firms remains to be seen. Note that demand in many sectors is yet to reach pre-pandemic levels. Accordingly, analysts caution, smaller companies would report higher margin compression in Q3FY22 than larger peers.

small is beautiful
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small is beautiful

Commenting on mid-caps in their coverage, analysts from Jefferies India Pvt. Ltd said in a report on 10 January, “Post a stellar H1FY22 (sales/profit after tax up +34%/+63% y-o-y on a weak base), we expect high y-o-y base (pent-up demand) and margin pressures (raw material inflation) to decelerate growth in Q3FY22."

True, the recent easing in commodity prices offers a breather. But its impact on earnings will reflect with a lag of a few quarters. However, till that happens, these stocks are exposed to risk of an earnings downgrade.

“We see risk of consensus earnings downgrades for consumer discretionary on slowing consumption volume growth on high price inflation seen last year and materials sectors as we expect 19% cut in steel prices in FY23–together these sectors constitute 30% of mid-cap index and are likely to be a drag on earnings," Amish Shah, managing director & head India research BofA Securities India Ltd.

That’s not all. The anticipated monetary policy tightening and withdrawal of stimulus is a general dampener for equities. In the event of a correction due to these factors, prices of mid-cap and small-cap stocks could see a sharper fall. This is simply because mid-caps tend to see a steeper rally than blue chips in a bull market; however, they fall equally harder when the market declines.

Valuations are another problem. Considering the consensus earnings growth estimates for FY23, the Nifty50, Nifty Midcap 100 and Nifty Smallcap 100 are trading at a price-to-earnings multiples of 20.68 times, 21.38 times and 19.48 times, respectively, shows Bloomberg data. Mid- and small-sized companies are trading at high valuations despite relatively weak fundamentals and higher vulnerability to downside risks. “Large-cap stocks are now trading at a discount to mid-cap stocks and almost at par with small-cap stocks versus a premium that large-cap stocks trade generally," Shah said. BofA prefers large-caps with contracting valuation premiums given the susceptibility of mid-cap and small-cap stocks to near-term headwinds.

“The biggest potential risk for investors is moderation in growth rate. If earnings growth falters then it can lead to massive de-rating of mid- and small-cap stocks’ valuation multiples," said Aishvarya Dadheech, fund manager, Ambit Asset Management.

Meanwhile, in Q3, investors in these stocks should watch out for management commentary on demand trends, price hikes, new launches and cost rationalization measures.

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