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Mid & smallcaps: Which direction from here?

May 6, 2010

After seeing a decline in the early part of this year, stocks of midsize and small size companies have outperformed their larger peers in recent times. The BSE Midcap and BSE Small cap indices have moved up by nearly 1% each over the past month and by about 8% and 5% respectively since the beginning of this year. The BSE-Sensex and the BSE-100 indices on the other hand have given negative returns in both these periods. About the movement of these indices over the past year or so, it is very well known. Stocks of small and mid-sized companies have by far outperformed their larger peers. We have written quite a few articles about our concerns over valuations and the upsurge in the movement of these indices. If we look at the chart below, it does seem as if it is one of those times.

Source: CMIE Prowess

On seeing the returns of the four indices - BSE-Sensex, BSE-100, BSE-Midcap and BSE-Smallcap, we can clearly see that the midcaps have been left behind in the race. Smallcaps on the other hand have outperformed the midcaps by a good margin. In fact, returns from the smallcap stocks are similar to that of the BSE-Sensex. As compared to the BSE-100 Index, they are marginally higher.

Going by history, more often than not, there has been some shakeup seen when such a situation has occurred i.e. whenever returns from stocks of small sized companies have done better than those of the larger stocks.

Apart from looking at the absolute returns, one should also consider the index valuations. However, this time around, the valuations do not seem to be in sync with the BSE-Smallcap index's movement. If we see the chart below, there seems to have been a quite a bit of change in the index's valuations since January this year. The index's PE (price to earnings ratio) has fallen from about 19 times to levels of 16 times. In the process, the gap between the valuations of the two indices does appear to have expanded.

Source: CMIE Prowess

Midcaps on the other hand seem as if they have some catching up to do. While midcaps have underperformed stocks from the other categories (in absolute terms), the story is different in terms of valuations. As the BSE-Sensex and the BSE-100 indices have given negative returns over the past few months, their valuations have moved down as well. In the process, valuations of the midcaps stocks seem to be quite close to that of its peers.

Which way the indices move is anyone's guess. But investors would do well to keep in mind that on an overall basis, stocks across categories do seem to be fairly priced. For example, the BSE-Sensex is trading at a PE of about 20 times. The average PE it has traded it at over the past five years is about 19 times. But it is quite obvious that investors are bullish about India Inc.'s financial performance. What else would be the reason for higher valuations?

Similar is the case for the smaller stock category. For small and midsized stocks to justify high valuations, their financial performance will need to move in tandem. In the result season so far, the financial performance of small and midsized companies has been quite decent. But then again, it would only be better if investors invest in good companies trading at attractive valuations.

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