The valuation discount of midcap and smallcaps has dipped of late, after having outperformed large cap stocks for nearly a year now. This has made some investors nervous about higher price to earnings (P/E) ratios. However, analysts at ICICI Securities believe it is not the right time to throw in the towel on midcap and smallcap stocks while adding that economic recovery will again fuel a broader market rally. Over the last one year, the Nifty 50 is up 53% while the Nifty midcap 50 index has zoomed over 80%. So far in 2021, the largecap Nifty 50 is up 12% while the midcap index has gained 25%.
Midcap, smallcap valuations distorted
“While the yield spread of mid and small caps over large caps has dipped sharply since the end of CY19 due to their outperformance, it has not disappeared or turned negative, which typically coincides with the peaking out of mid and small caps,” ICICI Securities said in a note. The valuations of midcap and smallcap stocks may be distorted by the significant loss pools thereby optically magnifying the numbers, according to the note. Meanwhile, Nifty 50 companies have reduced their loss pools, amplifying the said distortion.
For the previous financial year, in the small cap 100 index the loss pool contribution stood at 53% to the aggregate profit base of Rs 7,600 crore, while in the mid cap space the loss pool contribution was 42% to the aggregate profit base of Rs 32,300 crore, according to ICICI Securities. On the other hand, for the Nifty 50 index, the contribution to the loss pool was nearly 2% for the same time period. The note added that introducing loss making companies into aggregate index level calculations can completely distort the picture especially if the loss pools are significant as seen in the case of mid and small cap indices.
Going ahead, earnings are expected to be robust in the midcap and smallcap space over the next few years. “Given the significant loss pools in the small and midcap indices, earnings growth expectations over FY21 -23 are steep and not comparable to the NIFTY50 growth. However, removing the loss to profit companies, the growth expectations of mid and small caps appears stronger than NIFTY50 especially in FY23,” the note said.
Stocks to buy
ICICI Securities has picked 21 stocks from the midcap and smallcap space with high levels of earnings yield spread over large caps. Stocks with extremely high spread over largecaps and an earnings yield of more than or equal to 20% are Oil India, Power finance corporation, Karur vysya bank, and Garden Reach shipbuilders.
Stocks with more than or equal to 10% earnings yield include Federal bank, NHPC, CESC, Engineers India, Visaka industries, PTC India, and Shriram city union finance. Further, shares with moderately higher spread include Tata communications, Aditya Birla capital, Mahindra CIE, Kalpataru power, VRL logistics, Greenpanel , Bajaj Consumer products, and Mishra Dhatu Nigam. Lastly, stock with marginally higher spread over largecaps include ACC and TVS motors.
(The stock recommendations in this story are by the respective research and brokerage firms. Financial Express Online does not bear any responsibility for their investment advice. Please consult your investment advisor before investing.)