As investors make a dash for second-rung stocks on Dalal Street at the first sight of the bulls making a strong comeback, brokerages are treading this space cautiously.
Valuations of many of these stocks have turned reasonable. Price-to-earnings (PE) multiples for midcap and smallcap indices had expanded substantially from 12.9 times and 9.6 times in January 2014 to 23.1 times and 17.5 times in January 2018, respectively. But they then cooled down to 16.3 times and 11.2 times by January 2019, respectively.
High RoEs, above-average earnings yield and earnings growth visibility are among the criteria driving stock selection in this space.
“From a value perspective, our midcap and smallcap strategy would be to progressively buy market leaders within their sectors with high RoEs (> 15 per cent), earnings yield higher than the midcap average of 5 per cent and earnings growth expectation above nominal GDP growth,” ICICI Securities said in a report.
Midcap and smallcap indices had soared over 160 per cent during January 2014-2018. From there on, while Nifty advanced 5 per cent, the midcap and smallcap indices plunged up to 30 per cent till January 2019 on account of inflated valuations, re-categorisation of mutual funds by Sebi, corporate governance issues in several companies, macro headwinds and the liquidity crisis for NBFCs. Further, selloff of pledged shares also added to the carnage.
Historical data is clearly signalling a midcap recovery ahead. Way back in 2008 and 2013, when 30 per cent of BSE500 stocks had slipped below their 200DMAs, Dalal Street had found a bottom and turned a buyers’ market. More than 50 per cent of BSE500 stocks traded below their 200-DMAs as of March 11.
Current index levels suggest the broader market may have bottomed out. “Considering the robust earnings and attractive valuations, select midcaps and smallcaps are likely to rally over the next three-four quarters,” IIFL Securities said in a report.
Hopes of the Modi government retaining power in the forthcoming general elections have significantly improved investors’ risk appetite. Easing of geopolitical tensions has also boosted investor confidence, leading to a rally in these stocks. BSE Midcap and Smallcap indices have surged over 10 per cent and 13 per cent, respectively, since February 18, against a 4 per cent rise in BSE Sensex.
As many as 94 per cent of midcap and smallcap stocks delivered positive returns to investors in last one month, with Suzlon Energy soaring over 100 per cent and other top grossers being Rolta India (up 91 per cent), Punj Lloyd (up 74 per cent), BF Investments (up 60 per cent) and HG Infra Engineering (up 58 per cent).
At the same time, some stocks like Max India, KSK Energy, Optiemus Infracom and Vishal Fabrics declined 13-17 per cent in this period.
“Money cannot go around chasing the largecaps forever. The valuation gap has really become unsustainable,” says Kochi-based midcap investor Porinju Veliyath, who expects the broader market to deliver robust return from here on.
While Nifty can rally just about 2,000 points or so, hundreds of midcaps and smallcaps can double in the next one and one and a half years. Investors can adopt a bottom-up approach, Porinju said in an interaction with ETNow.
IIFL has recommended SAIL, Siyaram Steel Mills, Varun Beverages and Navneet Education from the midcap space with price targets of Rs 71, Rs 481, Rs 996 and Rs 133, respectively. The brokerage is also bullish on Capacite Infraprojects (price target Rs 286), JK Cement (Rs 977) and Inox Leisure (Rs 367).
ICICI Securities has named On the other hand, Balkrishna Industries, Galaxy Surfactants, Mahanagar Gas, Jagran Prakashan, Jubilant Life Sciences and Parag Milk Foods as its top midcap picks.