Higher valuation than Sensex makes mid caps a tricky choice

By: | Updated: November 12, 2014 12:26 PM

Selecting stocks from the mid-cap space has turned tricky for investors...

Selecting stocks from the mid-cap space has turned tricky for investors despite their potential to offer higher earnings growth over the next two years, thanks to the outstanding gains made by most of these scrips in the year so far.

On the back of a 50% rally so far in 2014, the BSE mid-cap index currently trades at a near-peak relative valuation to its large-cap counterpart, the 30-share Sensex. Currently, the mid-cap index is trading at a one-year forward price-to-earnings ratio of 15.77; the Sensex is trading at a P/E multiple of 15.57.

Mid-Caps

While more than a half of the BSE mid-cap universe has outdone year-to-date Sensex returns (31%), as many as 30 stocks from the 267 constituents have more than doubled this year.

Market experts say after three years of under-performance, mid caps had a high potential to catch up, but, now, as a general re-rating of the space may be over, investors ought to turn stock-specific, given that many of these are trading way ahead of their fundamentals.

According to Nilesh Surana, head of equity at Mirae Assets Global investments India, now that the overall valuation gap to the market has been breached, companies with scalable businesses and good earnings visibility should be preferred. “The focus should shift towards cash-flow generation from an optimism of re-rating potential,” added Surana.

In a recent strategy note, Axis Capital argued that while the mid-cap space usually does well when the economic growth surprises, individual mid caps have their own long-term sustainability shortcomings.

The brokerage used several financial and operational parameters, including EPS growth, RoE expansion, pricing power, scalability, ability to generate free cash and de-risked business model, to shortlist its mid-cap picks.

As per data compiled by Bloomberg, the consensus one-year forward earnings growth for the BSE mid-cap index with 267 stocks stands at 57% compared to a 24% growth projected for the top-30 companies that constitute the Sensex.

However, data also suggest that some of the frontrunners in the latest rally continued to demonstrate inferior financial performance in the last three quarters. For example, companies like BASF, Century Textile, Wockhardt, Muthoot Finance, State Bank of Bikaner, EIH and Hexaware Tech, which have either reported losses in the three months to September or seen profit growth decline in three of the last four quarters, have rallied anywhere between 60% and 85% in the year so far.

According to UBS, as small- and mid-cap stocks (SMID) have continued to rally after the election on hopes of an acceleration in growth recovery, many stocks are running ahead of fundamentals.

The brokerage noted that foreign inflows over the past 3-4 years have increasingly come from exchange-traded funds, Global Emerging Markets (GEM) and international funds, which are not big buyers of SMID stocks; inflows from dedicated India funds, on the other hand, have shrunk.

“While local institutions have finally started to see inflows, retail participation has increased. This provides technical support for SMIDs in the near term, as has arguably happened over the past 3-4 months,” noted analyst Gautam Chhaochharia in the report.

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