Pricey mid-caps climb to record highs

Analysts advise caution as valuation premium to Nifty soars to 13-year high

Mid-cap indices touched new all-time highs on Thursday, amid strong buying by foreign investors and optimism over the good and services tax (GST) Bill.

The NSE Midcap gained 0.7 per cent to 14,695, extending this month's rally to 6.4 per cent. The benchmark Nifty 50 gained 0.25 per cent to 8,666.3, a new 15-month high.

Experts say the market gains, particularly in mid-cap stocks, is being fuelled by easy foreign institutional investor (FII) buying. FIIs have been net buyers of domestic shares worth Rs 11,000 crore for 15 consecutive sessions. Record low yields in the developed world and talk of further stimulus have created benign liquidity conditions, spurring gains in equities.

Lack of further buying options in the large-cap space has also prompted FIIs to chase stocks in the mid-cap space, leading to expansion in their valuations. "The Nifty midcaps have rallied very sharply. Their P/E (price to earnings ratio) premium to the Nifty is at a 13-year high and is above levels seen in 2005, at the start of a sharp economic up-cycle. Mid-caps in that sense are already discounting a rapid acceleration of the Indian economy, an assumption that could come under stress in the short term," says Sanjay Mookim, India equity strategist at Bank of America Merrill Lynch.

Over the past year, mid-caps have progressively become more expensive than large-cap stocks. For instance, at the end of May 2015, the NSE Mid-cap 100 index was trading at a trailing 12-month P/E of 21.7, lower than the Nifty 50 trailing P/E of 23.1. The valuation began to move in favour of the mid-caps index from June 2015 and that index is now nearly twice as expensive as the Nifty 50 on a P/E basis, trading at around 42 times its underlying trailing earnings, compared to the Nifty 50's 23.6 times. The mid-cap index has rallied a little over 30 per cent from 2016 lows, compared to around 22 per cent gain on the Nifty.

The change in valuation dynamics has made things favourable for large-cap stocks once again, which puts mid-caps in a vulnerable spot. "Currently, large-caps are attractively valued against mid-caps and small-caps. Investors who want to take exposure to mid-caps need to have a long-term view," said Mrinal Singh, deputy chief investment officer at ICICI Prudential AMC.

Despite the sharp gains, there are still pockets of opportunities in the mid-cap space and investors need a stock-specific approach, say experts.

"In India, it is always been less about mid-caps as an asset and more about individual stock ideas. As an asset class, it does look very richly valued, compared to large-caps. It's at the top, so I will be cautious. But, even now, there are some compelling individual stock ideas," says Gautam Chhaochharia, head of research, UBS Securities India.