Higher dividend payouts keep mid-caps elevated

Companies in the mid-cap index pay nearly 50% more dividend per share than their peers in the Nifty 50 index

Mid-size companies have been the star of the bourses in the current rally. The Nifty Mid-cap Index has doubled since the lows of August 2013, more than double the appreciation in the benchmark National Stock Exchange (NSE)'s Nifty during the period. In all, the mid-cap index has given 10 per cent annualised return in the past five years, against six per cent by the benchmark index during the period.

Mid-cap companies, however, owe their stardom to higher dividend payout rather than superior earnings growth. The companies have stepped up the dividend payout ratio, which makes these look cheaper on the basis of dividend yield despite a poor earnings growth in the past five years.

The analysis is based on the daily closing value and valuation ratio for the two indices as reported by NSE. The underlying earnings per share (EPS) and dividend per share are calculated by inverting the exchange's reported price to earnings multiple and dividend yield.

A typical company in the mid-cap index now pays nearly 50 per cent more dividend per share than peers in Nifty50 index. Companies in the mid-cap index now distribute 45 per cent of their net profit as equity dividend, up from 22 per cent five years ago. The corresponding ratio for Nifty50 companies is 30 per cent now, against 25 per cent five years ago.

In all, the dividend per share for mid-cap 100 index companies has more than doubled (107 per cent) growing at a compounded annual rate of 15.7 per cent in the past five years. Earnings growth is flat and up by only two per cent cumulatively during the period. In comparison, Nifty50 companies' dividend per share is up 79 per cent against 39 per cent growth in their EPS during the period.

This has created a valuation wedge between mid-cap index and benchmark index. The mid-cap index is now 30 per cent expensive than Nifty 50 on price-to-earnings multiple but cheaper than the benchmark on the basis on dividend yield. In the past, mid-cap index used to be cheaper than the benchmark index on all counts.

Experts say sustaining valuation through higher dividend payout is difficult and this theme will fall flat if earnings growth remains tepid. "Mid-cap companies seem to be buying time in the hope that a likely faster earnings growth in future might take care of higher dividend pay-out and low profit retention currently. But, if the hopes are belied, companies might be forced to cut dividend pay-out negatively impacting their share price," says Dhananjay Sinha, head of institutional equity at Emkay Global Financial Services.

G Chokkalingam, chief executive officer of Equinomics Research & Advisory, senses a bubble in mid-caps and cautions investors against betting on the asset class. "Certainly, there is bigger bubble in the mid-cap index than in the benchmark indices. In the instance of a market decline, there would a deeper correction in mid-caps than large cap stocks that comprises benchmark indices."

He, however, cautions against painting all mid-caps with one brush. "There are still some quality mid-caps available at reasonable valuations. Investors should use the current rally to get out of frothy stocks in their portfolio and increase exposure to better stocks," he adds.