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Is the 'midcaps' party about to end?

Aug 6, 2015

In this issue:
» India Inc. is beginning to worry
» India tops business activity index in Asian region
» PE funds make a beeline for Indian real estate
» ...and more!


00:00
The last one year has particularly been a good one for the Indian stock markets. Expectation of big bang reforms from the newly elected Modi government set the prices of many stocks across market caps soaring.

That enthusiasm toned down a bit since the start of 2015. As India Inc declared its quarterly earnings, it became quite apparent that earnings growth remained quite subdued. What more, the pace of reforms that was envisaged did not really materialize. Obviously, expectations were too high in the first place. And so, not surprisingly, a spate of corrections began doing the rounds.

This is evident if one looks at the gains that the Sensex had delivered in the last one year; around 9%. But just because the appetite for largecaps seems to have waned a bit, it has not meant that investors have abandoned equities altogether. If the data for the past one year is anything to go by, investing in midcaps is what has caught the fancy of most investors. As can be seen from the table below, they have performed the best in the year gone by.

Midcaps have performed the best
Indices 5-Aug-14 5-Aug-15 Change
BSE Midcap 9,273 11,544 24.5%
BSE Smallcap 10,111 12,136 20.0%
BSE Sensex 25,908 28,223 8.9%
Source: Ace Equity

And the enthusiasm for midcaps continues. As reported in an article in the Economic Times, the midcap index has been buoyed by continuous buys from domestic mutual funds (MFs). Since the start of 2015, there have been inflows of over Rs 20 bn per month.

Other statistics mentioned in the article caught our attention. The midcap index is trading at a price to earnings (P/E) multiple of 24.5 times. The five-year average has been around 18 times. The Sensex, in the meanwhile, is trading at a P/E ratio of about 22 times. Historically, midcap index valuations have traded at a discount to the Sensex.

So is a correction imminent in midcap stocks? The answer may not be an easy one.

The fact that midcaps have performed better than largecaps is not surprising considering that the former have higher growth potential than the latter. But this growth has to command the right price. For instance, there are quite a few companies in the midcap space, which have seen valuations, shoot up to unsustainable levels of more than 40 times. And the earnings growth so far has not really justified these kind of valuations. Even after factoring in strong growth in the coming years, assuming that the pace of reforms and infrastructure spending accelerates, valuations of certain companies at 60-80 times earnings hardly makes much sense.

So in essence, logic dictates that all such stocks trading at very high valuations are due for a correction. But this may not happen. One reason for this is investment by MFs. As MFs get more and more funds from investors, they are compelled to invest these in stocks. As the pressure to invest this piles on, valuations are not necessarily given due importance. So in that sense, it will hardly be surprising if the prices of many midcap stocks and especially the good ones, will rise in the coming months as well.

But a prudent retail investor cannot determine his investing decisions based on what the MFs are doing. Indeed, the idea that prices of midcap stocks will continue to rise because the MFs are doing the same, is fraught with risks we believe. The retail investor might gain in the short term. But in the longer term he could end up having duds on his hand. Moreover, the investment objectives of mutual funds are different from those of retail investors. And this is something that the latter cannot afford to forget.

There is no doubt that midcap stocks do have bigger growth potential than their larger counterparts. But firstly, not all will be able to capitalise on this opportunity. Only the companies with good businesses and a right strategy in place will be able to grow consistently than the others. Second, valuations cannot be thrown out of the window. So even if you have spotted the good ones from the bad, if the stocks are trading at very high valuations, chances are that the average gains from these will hardly be much even if they are some of the best companies around.

In a nutshell, do not get carried away by the hoopla around midcaps, but instead try to gauge if the valuations that a particular company is commanding is worth the earnings growth potential of that company.

Do you think that valuations of most of the stocks in the midcap space have reached very high levels? Let us know your comments or share your views in the Equitymaster Club.

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02:25
As we have discussed above, one of the factors that has driven the rally across stocks, especially in midcaps, has been expectations of strong growth from the companies. Thus, what the government does in terms of fuelling this growth becomes very important.

And how has been the progress on this front so far? Not quite encouraging, unfortunately. India Inc. seems to be getting quite antsy about the fate of the investment climate of the country. The fears are not completely unfounded.

For instance, the Land Acquisition Bill has been put on the back burner. This bill was expected to play a big role in fostering development led growth. The introduction of the much awaited GST model also seems set to miss the deadline in 2016.

These developments coupled with the fact that earnings of India Inc have not really taken off so far is something to worry about.

One of the major gripes against the erstwhile UPA government was its inability to set the reforms process going. And so the current Modi government, will have to really up the ante, if it does not want to suffer the same fate as its predecessor.

03:10
 Chart of the day
A recent Livemint report observes that while global investors have pulled out about US$ 12.6 bn from emerging market funds in the three weeks to 31st July, India has only seen outflows of around US$ 358 m. So why have foreign investors been preferring Indian equity over its emerging market counterparts?

Today's chart of the day throws some light on this. The Purchasing Managers' Indices (PMIs), which measure manufacturing and services activity in the private sector, show that India has been doing better than most of its other emerging market counterparts on this front. Not surprising considering that the Indian economy is widely expected to benefit from the commodity deflation in the recent past. This, combined with the fact that Indian businesses are more reliant on domestic consumption demand compared to its peers, has led to business activity being relatively better-off here.

India tops business activity index in Asian region
Data Source: Market Financial Information Services

04:11
Moving over from business to real estate, the total unsold inventory in the sector in India currently stands at 7,06,900 units. And this may take over three years to sell, as per an Economic Times report. Yet Private Equity funds have been pouring in money in the sector. The aforementioned report highlights that PE funds have almost tripled their investments in India's real estate sector in the first six months of 2015. In total, they have invested Rs 112 bn in commercial and residential real estate during this period, up from Rs 40 bn in the year ago period.

So while the cash strapped and debt burdened builders have been struggling to complete existing projects and hold on to their inventory, it looks like the PE funds are coming to their rescue for now. Though we wonder how much longer this can go on for. Something will have to give sooner or later. And as and when this happens, builders will have to learn to let go of the high prices they are trying so hard to hold on to right now.

04:46
The Indian stock markets were trading on a volatile note today, crisscrossing the dotted line multiple times through the day. At the time of writing, the BSE-Sensex was trading up by around 74 points. Gains were largely seen in pharma and consumer durables stocks.

04:55
  Today's investing mantra
"As an investor with small capital, one should prefer businesses that have high returns on capital and that require little incremental investment to grow." - Warren Buffett.

This edition of The 5 Minute WrapUp is authored by Radhika Pandit (Research Analyst).

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3 Responses to "Is the 'midcaps' party about to end?"

AB Pereira

Aug 6, 2015

Some of todays Small and Mid caps are tomorrow's large caps. Just the way seeing the Sensex or Nifty is not right (compared to assessing each stock), it is not right to consider the Small or Midcap index which is skewed with several high PE companies that are purely speculative. But there are a few gems, which can be well justified based on their value - future value. A Force Motors may appear too hot to handle now, but that compares well with where Eicher Motors was, 2.5 years ago (Rs 3000). Today Eicher is 21000! There are many such value stories out there which will surely become ten-baggers or ton-baggers in the next decade. They need to be explored, thats all.
Did someone say risk? If so, why are we here? Have all the bank deposit accounts closed? Risks are there everywhere - even walking on the footpath, we may be swallowed by an unannounced footpath hole courtesy your 'hardly-working' local authority! or sleeping in your cozy bedroom, the building can collapse under heavy monsoon rains, courtesy your corrupt real estate operator!!

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G Darad

Aug 6, 2015

Your views appear to be firmly rooted in classical style of investing and is driven by a robust commonsense- exactly alike my thought process when I was not an investor (!), or for that matter, bordering on the thought process of the Oracle of Omaha. But please make some allowance for reaping some benefits from the insanity of the crowd - somewhat akin to the likes of the Lt. Parag Parikh hoped to encash. After all, we are here to make some easy money, are'nt we? Let a thousand insanity bloom, let the tribe of serious investors prosper! As long as astute investors like you and the huge institutional capital are present in the market, I am sure, we are in to rake in some handsome moolah. I just want to revel in the defeat of this mutual fund industry in their own game, so that the crowd thrashes them and returns into the retail market to take stock of things. Till then, let's engage in some well-meaning manipulation by serious art of stcock-picking.

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Ravindra

Aug 6, 2015

I agree with the analysis. There is too much money in the market and too few deserving stocks. As such when the investors, especially the retail investors realise the meagre returns on their investments (due to very high valuation), whether direct or through MFs, they will look for withdrawal of funds and alternative investments, maybe debt funds?? Real estate does not seem to be a candidate for direct investors.

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Equitymaster requests your view! Post a comment on "Is the 'midcaps' party about to end?". Click here!
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