Your money: Go for quality and beaten down midcaps with strong earnings visibility

Published: March 26, 2019 12:56:47 AM

We define quality stocks as those with a combination of high and consistent return on capital employed, increasing or stable operating margin, free cash flow positive, low leverage and high revenue growth.

The Long Term Growth Value (LTGV—value attributable to earnings growth beyond the next two years) of 53% is lowest since FY14.

After posting a high in January 2018, midcaps underperformed large caps in 2018 and shed their four-year streak of outperformance to large caps. Midcap universe is defined as companies whose average market cap rank is between 100 and 250 among the listed universe of companies. Year-to date (YTD), the midcaps (-0.75%), continue to underperform the Nifty (5.5%). We expect a revival in midcaps performance on the back of the following factors:

Historical evidence on price support and valuations
Historical analysis of midcaps reveals that (a) there has never been two consecutive years of negative returns; and (b) the positive returns in the year after negative returns have always exceeded the negative returns. Based on this observation, we expect the return from midcaps to exceed 15% in calendar year (CY) 2019 as against -15.3% in CY 2018.

The relative valuation of midcaps vs large caps are at a historically low level, both at an absolute level as well as on a rolling basis, with seven-day moving average (DMA) at 2014 levels. With four-year midcap-large cap premium practically wiped out, we now believe that valuations are reasonable to support midcap recovery.

Our proprietary framework also reinforces our view that midcaps are reasonably valued. The Long Term Growth Value (LTGV—value attributable to earnings growth beyond the next two years) of 53% is lowest since FY14. That said, the 30% (highest ever) Short Term Growth Value (STGV—value from earnings growth over the next two years) reflects optimism on earnings expansion.

Strong institutional flows to support rally

We expect strong foreign portfolio investment (FPI) flows in CY19 taking into cognizance (a) pause in Fed rate hikes which in effect weakens the dollar index and makes emerging markets (EMs) more attractive for FPI flows; (b) attractiveness of India relative to other EMs in a challenging global growth environment—India which is a consumption-led economy is well-placed unlike other EMs which export mainly to China; and (c) earnings recovery which is round the corner.

Expectation for strong earnings recovery in midcaps
The Nifty midcap consensus EPS CAGR between FY19-21 is at 22.4%, which provides a strong fundamental support, in our view. The Nifty Midcap100 EPS growth which incorporates for public sector banks earnings bounce back in FY19, looks steep (year on-year EPS growth of 97%) but on an ex-financials basis, FY19 earnings growth stands at 25% and the FY19-21 earnings CAGR is expected to be around 12%.
In the current environment, we recommend quality stocks and beaten down midcap stocks with strong earnings visibility. We define quality stocks as those with a combination of high and consistent return on capital employed (ROCE), increasing or stable operating margin, free cash flow positive, low leverage and high revenue growth.

-Edited extracts from Elara Capital’s India Strategy report

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