How do mid-cap valuations look right now? - Views on News from Equitymaster

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How do mid-cap valuations look right now?

Jan 3, 2012

Its official, the BSE-Sensex, down around 25% at the end of 2011, had its second worst yearly performance in fourteen years. With large-caps so badly beaten down, it is not surprising that midcap stocks, which are inherently riskier, would also be deeply under water. So, with the markets at seemingly rock bottom levels, the question on everyone's mind is whether this is the right time to re-enter the markets.

Below we have displayed a comparative data for both the indices - BSE-Sensex and BSE Mid Cap index.

Data Source: Ace Equity

If one had invested Rs 100 at the beginning of 2008 in the BSE-Sensex and the BSE-Midcap indices each, it would have been worth Rs 76 and 52 respectively. This indicates that the Sensex has outperformed the BSE-Midcap Index over this two and a half year period. You would have recovered some of your money in 2010's bull-run. However in 2011, policy inaction, interest rate hikes, a slide in the rupee value, and a slowing global economy all contributed to a poor showing for Indian stock markets. The BSE-Midcap Index has underperformed the BSE-Sensex over the last year. While the BSE-Sensex has fallen by 25% over the last year, the BSE-Midcap Index has fallen by 35%. So does this sharper fall make midcaps more attractive versus their larger peers? Let's find out further.

The best way to gauge the attractiveness of midcap stocks is to look at their price to earnings ratio (PE). A better way to gauge the same is by comparing the valuations of the BSE-Midcap Index with the benchmark index, the BSE-Sensex.

Below is a chart indicating the PE ratios of both the indices since 2008. We have also shown the average PE ratios of both these indices during this four year period. While there is no doubt that the BSE-Midcap Index would trade at lower valuations as compared to the BSE-Sensex (as these stocks are comparatively smaller and riskier), the main question is that despite this, are midcaps attractive at this point in time?

Data Source: Ace Equity

We shall look at the next chart to find out. Below is a chart displaying the difference in valuations over this period. We have calculated the same by dividing the PE ratio of the BSE-Sensex by the BSE-Midcap Index.

What does this convey? Well, as the ratio moves towards the 1 times mark, this means the difference in the PE ratios of the two indices is less. This could mean two things - Either that the Sensex is undervalued or that midcaps are expensive.

Data Source: Ace Equity; *Average period considered as Jan 2008 till date

Similarly, when the ratio drifts away from the 1 times mark, this could indicate that the BSE-Sensex is expensive or that the midcap stocks look fairly attractive.

What does it seem like at this point in time?

Well, considering that the BSE-Sensex is trading at a price to earnings of about 16.4 times, it seems to be on the cheaper side (as compared to its ten year long term average valuation of about 18 times). The current levels are also much lower than the three year average of over 19 times. The BSE-Midcap Index is currently trading at 14.4 times, which is lower than its past three year average of 16.5 times. This shows that there is still scope for both these indices to move upwards. The BSE-Midcap Index's valuations seem to be quite close to its three year average of 0.8 times, making it an attractive level to enter. However, given the current investment scenario it may still take some time for these indices to recover. Some sectors have been severely beaten down in 2011, and it would be interesting to look at some stocks in those sectors. One needs to dig for some mid-cap stocks which have strong managements, a wide moat and an ability to maintain margins. With valuations at two and a half year lows it makes sense to look for companies with such advantages. It will really pay off over the long term.

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