From L&T Infotech to Tata Elxsi, mid-cap IT stocks lagging large-cap peers

Their m-cap is up 5% this month, against 11% rise in large-cap IT stocks

Mid-cap IT services stocks, such as L&T Infotech, Mindtree, Mphasis, Oracle Financial Services, and Tata Elxsi, are under pressure after outperforming their large-cap peers by a big margin in the pandemic period. The market capitalisation of mid-cap IT stocks is up 5 per cent on average during August, against an 11 per cent rise in the market capitalisation of large-cap IT stocks. Mid-cap IT stocks are now underperforming the broader market, too. The BSE Sensex is up 6.1 per cent during the month, so far.
 
Between March 2020 and July this year, mid-cap IT stocks were among the best performers at the bourses and rallied more than two times the rise in their large-cap peers. The combined market cap of mid-cap stocks was up 281 per cent between March 2020 and July 2021, against a 107 per cent surge in the market capitalisation of large-cap IT stocks. The benchmark index was up 78 per cent during the period.
 
The analysis is based on a constant sample of 16 IT stocks with a current market capitalisation of Rs 10,000 crore or higher. Of these, five stocks — that are part of the Nifty50 index — are in the large-cap category, while the rest fall under the mid-cap segment.
 
The five large-cap IT companies now have a combined market cap of around Rs 28 trillion, while mid-cap companies in the Business Standard sample have a combined market capitalisation of Rs 3.6 trillion.
 
Analysts expect mid-caps to continue to underperform for some time more. “Mid-cap IT stocks as a category are likely to underperform large-cap IT stocks, given their record high valuation and margin pressure that many companies are facing due to wage inflation," says Shailendra Kumar, CIO, Narnolia Securities.
 

Over the past one-and-a-half years, the price-to-earnings multiple for mid-cap IT stocks is up more than two-and-a-half times from 13.9x at the end of March 2020 to 35.4x currently. During the same period, the P/E multiple of large-cap IT stocks doubled from 16.8x in March 2020 to 33.7x now.
 
As a result, for the first time in three years, mid-cap IT stocks are trading at a valuation premium to their large-cap peers. Historically, mid-cap IT stocks have generally traded at a discount to their large-cap peers.
 
According to analysts, the valuation premium is not sustainable and will revert. “The valuation premium for mid-cap IT stocks has become challenging. We can expect some correction here, even as large-cap IT stocks may continue to do well," says Kumar.
 
Analysts, however, point out that select mid-caps may continue to do well, thanks to their strong order book and potentially double-digit growth in earnings over the next two years.
 
“There are still quite a few quality mid-caps in IT space that can give a run for their money to large-cap stocks due to their ability to grow faster. So, I advise investors to stay invested in quality mid-cap stocks in the sector,” says G Chokkalingam, founder & MD, Equinomics Research & Advisory Services.
 
He also sees potential acquisition targets in the mid-cap IT space that offer big gains to investors. Most acquisitions occur at a premium to the market price and stocks get rerated post-acquisition, offering big returns to early investors.