Prefer Bluechips over midcaps in current market conditions
Several stocks and indices, including the Nifty, and the small-cap and mid-cap index, climbed to record highs in FY17, on hopes of a turnaround in the economy and earnings. The benchmark Nifty and the Sensex rose 19 per cent and 17 per cent, respectively, aided by strong domestic and foreign inflows.
The broader market outpaced the benchmarks. On the BSE, the S&P small-cap index surged 37 per cent and the mid-cap one by 33 per cent. It was the second-best performance for these indices in seven years. India’s mid-cap stocks outperformed the benchmark S&P BSE Sensex Index for the third straight year on better-than-expected earnings and higher domestic inflows. A strong inflow of over Rs 1 lakh crore collectively by foreign portfolio investors (Rs 55,680 crore) and domestic mutual funds (Rs 51,293 crore) in the year led the rally. During the year, the 50-share Nifty surpassed its previous high, made in March 2015, while the Sensex missed clocking a new high by just one per cent.
Be it the US Fed rate hike, Trump’s unexpected victory or the historic exit of Britain from the Euro Zone, Indian markets have shrugged off global risks with aplomb, over the past year. The BJP’s victory in recent Assembly elections, the passage of the GST Bill in Parliament and improving macros, such as sharp reduction in current account deficit and narrowing trade balance, have been a big draw for foreign investors.
High returns from mid and small-cap stocks in the last couple of years have boosted flows from retail investors into schemes that invest in these companies. With a mandate to buy mid-caps and micro-cap stocks, fund managers have no choice but to look for small-cap companies with market capitalization between Rs 800 crore and Rs 3,000 crore. The mid-cap index not only trades at a 37 percent premium to the Sensex, but also at a 19 percent premium to its five-year average price-to-earnings ratio.
Mid-caps had started trading at a premium to large-caps from 2014 onwards. The BSE Mid-cap index premium over the Sensex, 10.3 per cent in 2014, rose to 28.7 per cent in 2015 and was 21.3 per cent in 2016. The S&P BSE Sensex currently trades at 17.3 times the estimated calendar year 2017 earnings, while the BSE Mid-cap index is at 18.7 times, by Bloomberg calculations. The premium commanded by mid-caps vis-a-vis the Sensex has thereby reduced to 7.5 per cent.
The current valuations of many midcaps stocks are at their all-time highs. Few stocks are in bubble zone with their valuations stretched far from their fundamentals. To justify the current prices, these companies will need to grow their earnings multiple times in the next two years. This earnings growth looks rosier than expectations based on ground realties.
Investors have to stop chasing midcap and small cap stocks as they have expensive valuations and provide limited upside from current levels. Large cap stocks which have underperformed over the last three years provide good investment opportunities as they are still trading at comfortable valuations. Limited opportunities in mid and small cap space makes the consistent fund flows into market makes investors to look for large cap stocks. These stocks are expected to outperform over the next 2 years. Investors who have much their portfolio exposure to midcap stocks, should slowly tilt it towards large cap stocks by selling expensive midcap stocks.