No longer discounted: Mid- and small-cap IT firms enjoy premium at bourses

The rally in mid- and small-cap stocks has spilled over into the IT sector as well. Second and third-tier IT stocks, which historically traded at a discount to the big five IT companies, are now trading at nearly 25 per cent premium to their large-cap peers.
 
The smaller IT companies have a price-to-earnings (P/E) multiple of nearly 38 times against the big five’s current P/E multiple of around 31x.
 
This is a contrast to last year, when mid- and small-cap IT companies traded at a P/E multiple of 13.3x at the end of March 2020, while large-caps had a multiple of 18.9x.
 
This premium is largely down to a sharp rise in the stock price and market capitalisation of mid-cap IT companies such as L&T Infotech, Mindtree, Mphasis, L&T Technology, Persistent Systems, Coforge, and Tata Elxsi, among others.
 
Analysts attribute this to investors’ expecta­tion of faster earnings growth in smaller firms. “Most investors expect mid- and small-cap IT firms to report faster earnings and revenue growth over the next 2-3 years compared to their large-cap peers,” says Shailendra Kumar, chief investment officer, Narnolia Securities.
 
According to him, smaller firms reported better margin expansion in financial year 2020-21 (FY21) on the back of superior cost control compared to their large-cap peers.

 
The rally in mid- and small-caps has also been driven by growing participation of retail investors. “Record numbers of retail investors have entered the equity market and they largely invest in mid- and small-cap names,” says G Chokkalingam, founder and managing director, Equinomics Research & Advisory Services.
 
Chokkalingam also attributed the rally to the potential acquisition of the mid- and small-cap IT firms. “Many smaller IT companies are potential acquisition targets, which is driving their valuations,” he adds. 
 
The combined market capitalisation of mid- and small-cap IT companies is up nearly 4x since March 2020, against 84 per cent rise in the market cap of large-cap IT companies.
 
These smaller firms had a combined market cap of Rs 4.34 trillion on Wednesday, as against Rs 1.14 trillion at the end of March 2020, and Rs 2.85 trillion at the end of December 2020.
 
In comparison, the large-cap companies’ market capitalisation grew from Rs 13.8 trillion at the end of March 2020 to Rs 25.4 trillion on Wednesday. The large-caps have moved in tandem with the BSE Sensex since the beginning of 2021, as against a big outperformance by their smaller peers. The analysis is based on the quarter-end and latest market capitalisation and earnings of the 26 IT companies that are part of the BSE500 index.
 
The 26 IT companies had combined market capitalisation of around Rs 30 trillion as on Wednesday. The top five companies that are part of the benchmark indices, which are large-caps, are Tata Consultancy Services, Infosys, Wipro, HCL Technologies, and Tech Mahindra. The rest belong to the mid- and small-cap space.
 
The big five account for around 85 per cent of the industry’s combined market capitalisation and nearly 90 per cent of revenues.
 
Analysts are, however, cautious about the prospects of mid- and small-cap IT stocks. “The valuation premium of mid- and small-cap IT over large-cap is now beyond the comfort range, and I am underweight on smaller names,” says Kumar.