Before this unexpected market rebound got underway, market watchers believed that large-cap stocks were the best option to ride a recovery wave. Mid-cap stocks were widely expected to lag large-cap stocks in a rebound, given the latter’s superior ability to survive a downturn.
But the reality has been different, with mid-cap and small-cap stocks losing no time in catching up with, and even surging ahead of, large-caps. With investors busy ferreting out less expensive stocks, the wide gap between the valuations of large and mid-cap stocks has not gone unnoticed. With the majority of mid-caps available at single-digit valuations, these stocks have swiftly caught the market’s attention.
The 86 per cent and 92 per cent returns notched up by the BSE Midcap and Smallcap indices respectively from their March 9 lows, have trounced the Sensex returns of 70 per cent.
This does not necessarily mean that large-caps have put up a mediocre performance. Large-caps, believed to be safer bets during a volatile market, did revive ahead of mid and small-caps in the initial part of the rally. Between January and March 2009, the Sensex turned in positive returns (0.6 per cent), even as the BSE Midcap Index declined by 9 per cent in those three months. However, as the rally extended into May, the returns changed: The Sensex has returned 44 per cent on a year-to-date basis, against the 47 per cent returns of the BSE Midcap index. The BSE Smallcap index is a cut above, delivering 50 per cent.
The learning here is that while investors’ portfolios would have first responded to the large-cap rally; had they held on to their smaller stocks with some conviction, they would have been amply rewarded.
Mid-cap stocks have suffered from poor investor appetite for much of the period after the market crash last January.
Low market liquidity, deteriorating financials and the smaller companies’ greater vulnerability to rising interest rates prompted even domestic institutions such as mutual funds, to adopt a large-cap stock bias over the past year.
But the result was that valuations for these stocks probably factored in the worst-case scenario. The price earnings multiple of the BSE Midcap and Smallcap indices (source: BSE) as of March 9 stood at 8.6 times and 5.9 times respectively, as against 11.6 times for the Sensex. This gap has, in fact, widened towards the end of May (see Table).
Ample liquidity flows, with the FII turning positive on India from mid-March, combined with quite a few companies coming up with better-than-expected numbers, resulted in smaller companies too attracting investor interest.
Of the 130 companies (out of 222) in the BSE Midcap index that have so far come up with their March quarter results, at least 57 recorded a 10 per cent sequential profit growth. This suggests that these stocks deserved valuations higher than the P/Es of 2-8 times accorded to them until then.
The takeaway here could be that at beaten down valuations, companies that have had reasonable earnings growth in the past, could well deliver realistic performance though not at levels delivered in FY-08. These stocks would have been the ‘value picks’ had investors identified them between January and April, or earlier.
Note that the fancy for cheaper stocks has also helped in marking up stocks without a strong claim to fundamentals and those for whom earnings prospects remain quite uncertain.
The mid-sized and smaller stocks in the real estate sector could be a classic example, where demand had nearly come to a dead end and there aren’t yet too many signs of revival.
That suggests that there is a case for investors in the mid and small-cap space to take selective profits, based on valuations at this point in time. Mid- and small-caps are known for delivering quick gains compared with large-caps. So how does one identify a bubble in these stocks?
Experience from late 2007 suggests that the convergence in the P/E ratios of the mid-cap index with the Sensex is one indicator of a bubble building up in smaller stocks.
The market meltdowns in May 2006 and January 2008 happened soon after mid-cap valuations overtook Sensex valuations.
On this count, this particular rally in mid and smaller caps may not have run its course.
The current P/E ratios of the mid- and small-cap indices are now at 14.7 and 12 times (according to the BSE) even as the Sensex valuations have shot up to 19 times.
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