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MUMBAI : Midcap stocks are losing sheen following a stellar performance so far in 2021-22. At current levels, the valuation premium of BSE Midcap over Sensex has narrowed from 20% in April to 9.6%, a Mint analysis showed. Valuation premium of BSE Midcap over the Sensex has seen a sharp decline from a peak of 37.67% hit on 4 November 2020, according to an analysis of data over a period of four years. The premium of BSE Midcap has shrunk primarily because of the over-heated valuation of the Sensex, which is at a one-year forward price to earnings (PE) of 24.03 times according to Bloomberg data, analysts said.

“BSE Midcap earnings were revised upwards on 13 August, post the completion of June quarter results. This led to a fall in the PE ratio of BSE Midcap index. The earnings revision in the Sensex was gradual and less than the Midcap index. Hence, the valuation premium of the Midcap index over the Sensex has optically narrowed since the beginning of FY22," said Deepak Jasani, head, retail research, HDFC Securities.

The premium of the BSE Midcap over Sensex is now close to the average or median since April 2017, he said. “While this may keep changing based on the earnings revision in respective indices and shift in buying between the two categories of stocks, we think that though the valuations of both indices are high compared to historical numbers, they are not excessive and the relative valuations are also in line," he said.

At current levels, BSE Midcaps is at 26.35 times based on one-year forward earnings, while BSE Smallcap index is cheaper at 22.60 times. BSE Midcap was at 26.31 times one-year forward PE in the beginning of FY22, but Sensex was a bit cheaper at 21.86 times, while BSE Smallcap was at 20.30 times.

Conversely, the valuation of BSE Smallcap is at a 5.9% discount to Sensex at current levels from a discount of 7.15% in April. In August, the valuation of BSE Smallcap was at a 3% premium (highest in FY22) over the Sensex. During the same period, one-year forward PE of BSE Smallcap was at 22.50 times, while Sensex was at 21.84 times.

Earnings support will be critical to justify the steep valuation of the markets. There may be uneven recovery in corporate earnings for the September quarter, as the Indian economy opened up with a drop in covid-19 cases, analysts said. Midcap firms that analysts of Reliance Securities are tracking will report 26% year-on-year (y-o-y) growth in revenue, while sequentially revenue is likely to remain flat in the second quarter of FY22, they said. Earnings before interest, taxes, depreciation and amortization margin is expected to contract by 50 basis points y-o-y due to higher input costs. Net profit of the midcap firms is expected to grow 34% y-o-y, but it may decline 1% quarter-on-quarter.

“We expect the companies under coverage to deliver a flattish sequential growth, but strong y-o-y uptick on a lower base. We believe sustainability of the demand recovery seen from June is likely to continue, as there is very low probability of an impact coming from a third covid wave," Reliance Securities said. So far this year, both the BSE Midcap and BSE Smallcap with gains of 49%-65% have outpaced the Sensex, which has risen 28%. However, analysts fear that the euphoric rise in smaller stocks may be vulnerable to shocks during a market correction.

“Midcap and smallcap stocks suffer from over dependence on a single line of business or a small set of clients. This makes them more vulnerable to price shocks and changes in fortunes of the line of business. Also, when inflows into these categories of stocks rise and opportunities to invest are limited, valuations of these categories become abnormally high, raising the possibility of a bubble formation and subsequent crash," Jasani of HDFC Securities said.

When the tide turns and selling starts in these stocks, it could be hard to find buyers, he said. “This is a genuine liquidity risk for these stocks which is visible during deep sell-offs. Large falls in the value of these stocks are seen on thin volume trade," he warned.

Over the past 12 months, Indian markets have been outperforming global peers. MSCI India has outperformed MSCI Emerging Markets index. In PE terms, MSCI India is trading at a 93% premium to the MSCI EM, above its historical average of 58%. Abundant liquidity, declining covid-19 cases, upbeat corporate commentaries and low cost of capital lifted valuation multiples to stratospheric levels for high-quality names across sectors, said Motilal Oswal Financial Services.

However, rising energy and commodity prices, disruptions in global supply chains and speculation around the US Federal Reserve’s tapering move and the eventual normalization of the interest rate environment in 2022 could keep the markets volatile, it said.

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