Mid-caps on the edge

Valuations pip blue-chip and indices; experts advice caution as correction looms

Small-cap and mid-cap shares could see a serious fall if the weakness in the market continues, say experts.

This stems from a change in valuations. After two years of good performance, the price to earnings (PE) multiple of mid-cap and small indices have soared past that of the benchamrk Sensex and Nifty. The PE multiple of the NSE Midcap 100 index, for instance, is currently 23 per cent more than the Nifty. In 2014, when the market rally had begun, the Nifty traded at a 25 per cent premium to the mid-cap index.

For many, a sharp increase in valuations of small-cap and mid-cap companies over blue-chips is a signal for an impending correction. Lack of earnings support, coupled with a drop in risk appetite, make the shares of smaller companies vulnerable to sharp falls, say experts. A glimpse of this was seen on Wednesday, when the mid-cap and small-cap indices fell a little over four per cent before recovering slightly.

“Historically, they (small and mid-caps) have been traded at a discount of five to 20 per cent to large-caps. Now, mid-caps are actually trading at a premium, which is a risk,” said Harsha Upadhyaya, chief investment officer, equity, Kotak Asset Management.

In 2014, when Sensex gained 30 per cent, the small and mid-cap indices had both soared over 50 per cent. Last year, when the Sensex fell five per cent, the BSE Smallcap and Midcap indices had gained around seven per cent.

Credit Suisse says relatively less foreign institutional investor (FII) ownership and lower exposure to globally stressed sectors has helped the mid-caps to outperform. It says FIIs own 23 per cent of the Nifty but only 14 per cent of the NSE Midcap. As the latest correction was led by foreign investor sell-off, blue-chip stocks bore the bigger brunt.

Also, a large part of the mutual fund inflows seen last year went to mid-caps. Experts think 40-50 per cent of MF flows might have got invested in small and mid-cap companies.

“While the second reason (less exposure to global stress) for outperformance might persist in 2016, one would need to see the flows as well to argue again for any bucking of the trend,” said a Credit Suisse note. It observes mid-caps are still at a discount to large-caps on a price to book (P/B) basis.

According to data provided by NSE, the Nifty currently trades at a trailing 12-month PE of 20, while the Midcap 100 index trades at 27.

To be sure, the valuations of mid-cap and small-cap indices aren’t as reliable as of the Nifty or Sensex, as a lot of the components in the former are loss making or see huge fluctuations in earnings.

“The valuation re-rating of mid-caps is now pricing in most of the benefits from expected uptick in growth and lower rates. Although not the case for the entire set, select mid-cap stocks seem overvalued and, hence, a degree of caution is warranted in buying mid-caps,” said Gautam Roy, vice-president at Motilal Oswal AMC.

Most experts are advising investors to make short-term bets on the small-cap and mid-cap space, even if there is a fall.

“We are promoting large-caps. If an investor is coming into mid-caps, we are telling them not to worry about the next six months' performance. But, over a five-year period, even at these higher valuations, mid-caps will give you returns,” said Upadhyaya.