Elections and stock market: Why midcap stocks rallied after previous polls; what to buy now

We are of view that impending elections is bound to bring bout of volatility, but this should be taken as an opportunity by astute investor to invest in quality businesses.

Elections and stock market: Why midcap stocks rallied after previous polls; what to buy now

Indian equity markets (Nifty 50) have delivered a resounding 14.9% positive return in FY19, but most of investor portfolio continues to underperform. The reason being broader market largely remained in negative territory in the last financial year compared to stupendous return of Nifty 50. NIFTY MIDCAP 100 and NIFTY SMALLCAP 100 delivered return of -2.7% and -14.4% respectively over the same time frame.

The reason of Nifty 50 outperformance is primarily due to six Nifty stocks, which attributed to more than 2/3th of Nifty gains in last one year, whereas other constituents of index either remained negative or largely flat. This acute polarization of stock return is primarily due to investor intent of chasing quality in times of weak earning visibility over last two years.

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This has led to huge divergence in the valuation of large caps and midcaps. At the start of Jan 2018, when Midcap index was at all-time high, it was trading at more than 40% premium to large cap index (premium at highest level ever in last decade). Post that, Midcap index has underperformed the large cap, primarily due to macro headwinds and unsustainable valuation premium to large caps. After an intense drawdown in broader market and sharp underperformance in CY18, valuations are now much more reasonable (10% discount to large cap) as against the all-time highs seen in Dec17 (40% plus premium).

During the same time period the earning downgrades in midcaps have been much lower than large caps, and we believe the earning momentum which is gaining steam since last 2- 3 quarters will gain pace further. The earning trajectory of midcap companies will benefit disproportionately more, from the low interest rate scenario which is expected to continue, given low inflation expectations. Added to that, severe NPA recognition cycle, adverse impact of GST and demonetization, volatile commodity prices (especially Crude) which has impacted earning in last 2 years are now past and have created favorable base impact.  

We are of view that impending elections will bring in a bout of volatility, but this should be taken as an opportunity by to invest in quality businesses. Again, though it is not obligatory that history always repeats itself. But if one looks at 6 months market return post every Lok Sabha elections outcome, in this 21st century, midcap has massively outperformed large cap. The average outperformance of midcaps over large caps has been more than 20%. The reason which can be ascribed to this phenomenon is that money start flowing into quality midcap & small cap names once the uncertainty of political scenario is over.

We believe there is renewed investor interest in quality midcap stocks as headline valuations indicate perceived value. There are selective midcap names where the investment thesis of buying earning growth at reasonable valuation hold true in current scenario. Investor should focus on good & clean companies where there is structural earning growth visibility, with strong return ratios and scale able business, run by competent management.

(This article has been authored by Aishvarya Dadheech, Vice President & Fund Manager at Ambit Asset Management. Views expressed are author’s own. Please consult your financial advisor before making any investment related decisions)

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