Thanks to the stocks rally this calendar, the valuation discount of smallcaps and midcaps to their largecap peers has dipped, but not disappeared, say some analysts. What you see is a significant loss pools distorting the picture. So don’t throw in the towel on midcaps and smallcaps yet, they say.
Vinod Karki and Siddharth Gupta of ICICI Securities argued that the Smallcap100 index’s loss pool for FY21 stood at 53 per cent of the aggregate profit base of Rs 7,600 crore, while in the midcap space, the contribution of the loss pool was 42 per cent of the aggregate profit base of Rs 32,300 crore. On the flip side, the contribution to loss pool in the Nifty50 pack was about 2 per cent for FY21.
“Negative earnings are meaningless for analysing P/E or earnings yield ratio of a stock. Introducing such companies to aggregate index level calculations can completely distort the picture, especially if the loss pool is significant as seen in the case of midcap and smallcap indices,” the duo said.
Nifty Midcap 100 today trades at a P/E of 34.37 times and Nifty Smallcap 100 at 42.22 times. In comparison, Nifty50 trades at 29.05 times its earnings, data available on NSE showed.
In other words, smallcaps and midcaps look more expensive because many of the companies in both the indices are in losses, inflating the overall P/E levels. Hence, in reality, the picture is not that bad, as long as we can avoid the rotten apples in the basket.
“Managing risk becomes paramount while investing in the broader market, and investors should steer clear of speculative stories that are not supported by adequate earnings yield, growth prospects and quality of business,” say Karki and Gupta.
This has become critical, especially after the significant outperformance since CY20 which has taken away a significant amount of ‘margin of safety’ from midcap and smallcap stocks. Since December 2019 end, Nifty Midcap Index is up 58 per cent while Nifty Smallcap Index has risen 67 per cent. In comparison, Nifty has added about 30 per cent. But this does not mean the broader market stocks have no upside left.
“As economic recovery gains traction over the next couple of years, the earnings growth for the broader market over the latter part of FY21-23 will be robust and are expected to be higher than Nifty50’s growth. Improving growth can support valuations in the broader market, and thereby, provide moderate returns (10-15 per cent), given the reduced valuation gap with largecaps,” Karki and Gupta said, adding that expectation of a sharp outperformance from midcaps and smallcaps going ahead will be belied.
They shortlisted 21 stocks from the midcap and smallcap segment from ICICI Securities’ coverage universe with a fundamental ‘buy’ rating and high levels of earnings yield spread over largecaps.
- In the ‘marginal’ earnings yield bracket are ACC and TVS Motors
