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Small and midcaps rally, but valuations and earnings in sharp contrast for some

Investors should note that there are downside risks to margins from rising commodity prices, which can hurt small- and mid-cap companies more than large caps.Premium
Investors should note that there are downside risks to margins from rising commodity prices, which can hurt small- and mid-cap companies more than large caps.

  • Valuations are rich, not just for small- and mid-caps but for the Indian equity market. An Edelweiss Securities' analysis shows there is a gap between large-caps and small- and mid-caps across sectors, despite earnings of the latter catching up

MUMBAI: Small- and mid-cap stocks are back in action. The S&P BSE Smallcap index rose to a record intraday high of 20,290 points on Thursday, scaling past the previous high of 20,183 seen in January 2018.

A combination of favourable factors is aiding this up surge - the ongoing economic recovery and consequent improvement in the earnings performance of these companies. Typically, small- and mid-cap stocks tend to do well when the economy is performing well. Apart from that, these stocks have also been benefiting from the gush of liquidity sloshing around equity markets, thanks to the accommodative stance of central banks globally.

Also Read | The limits to India’s privatization push

However, there are risks to this rally which shouldn’t be ignored. Valuations are rich, not just for small- and mid-caps but for the Indian equity market as well. An analysis by Edelweiss Securities Ltd shows that there is a gap between large-caps and small- and mid-caps across sectors, despite the earnings of the latter catching up.

“The current market rally closely resembles the rally post GFC (2008-09), not just in quantum and speed, but also the way SMID indices have outperformed large-cap indices. As the hunt for laggards intensifies, we highlight potential pockets of valuation gaps between large and small and midcaps. Prominent among these are IT/ITES, Cement and Pharma, wherein some small caps are at a reasonable discount (15-50%) to large-cap peers," said the domestic brokerage house in report on 25 February.

The Edelweiss research also shows that this rally has seen some directional mismatches as well. “While instances where FY22 earnings have seen an upgrade (vs. Jan 2020) and valuation multiples have contracted are very few (in fact, only 10-12 within 100th-650th), there are more than 50 stocks where the valuation multiple has expanded >15% even as FY22 estimates are down 15%+ compared to a year back," added the report.

Investors should note that there are downside risks to margins from rising commodity prices, which can hurt small- and mid-cap companies more than large caps.

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