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Midcaps v/s Sensex: Attractive or not?

Jun 21, 2012

A few days ago, we had taken a look at how smallcaps stocks have performed over time and how their recent valuations stack up when compared to the blue chip stocks.

In this article we shall look at the similar data for midcaps and the BSE Mid Cap Index.Traditionally, midcaps have traded at a discount to their larger peers in terms of valuations. The same is displayed below.

PE ratio of the indices over the years (till Nov-11
Data Source: ACE Equity

Above is a chart of the price to earnings ratio (PE ratio) of the two indices since March 2006 (earlier data not available). You can easily figure out that for most part of this duration, midcaps have traded cheaper than the large cap blue chip stocks.

But, this has been the case till February 2012!

Let's take a look at how the valuations have changed in the past six odd months.

PE ratios since December 2011
Data Source: ACE Equity

As you can see, midcaps seem to have become more expensive when compared to the stocks forming part of the BSE-Sensex in the last few months.

Now, let's take a look at some figures.

The Sensex has traded at a valuation of about 20 times since March 2006. On excluding the top and bottom 10% multiples (for cases of extreme pessimism and optimism), the average remains the same.

As for the BSE-Midcap Index, the average P/E multiple stands at about - 17.7 times over this period. On excluding the top and bottom 10% values, the average in fact moves up to about 18 times.

We can conclude that over this period, Mr. Market has valued midcap companies at a discount of about 10% (18/20) when compared to the valuations garnered by the stocks forming part of the Sensex.

At present, the BSE-Midcap Index trades at 17.6 times, which is still below the average. But at the same time, one must remember that the BSE-Sensex itself is trading at a discount to its longer term average. The index is currently trading at multiple of 16.5 times.

Now, why is the case like this?

It is due to the denominator of the P/E ratio, the EPS. The chart below displays the scenario well.

Change in EPS over the years
Data Source: ACE Equity

As you can see, the EPS of midcap companies have declined in recent times, while that of the blue chip companies has been on a steady rise.

What to make of all this?

The BSE-Sensex has traded at an average of 18.7 times since Jan 2000, which is a long period covering many ups and downs. On excluding the top and bottom 10% multiples, the average multiple comes to a marginally lower figure of about 18.56 times.

Relative PE Midcap Sensex
Data Source: ACE Equity

Going by the available data, midcaps have traded at about 0.9 times (0.887 times to be precise as displayed in the chart above) that of the Sensex's PE valuation.

0.9 X 18.56 = 16.7, is what ideally the midcaps have traded at historically, over the last twelve odd years.

So yes, purely in terms of valuations, midcaps seem to be on the expensive side given that current valuations stand at 17.6 times.

So for the index to reach its average valuations, its price would need to contract from here on given that the current PE Ratio is higher than the average. Or the EPS would have to go up marginally.

But the question is - What is Mr. Market expecting?

Devanshu Sampat

Devanshu Sampat (Research Analyst) has a degree in commerce and nearly 5 years of experience in equity research. He draws inspiration from successful value investors across the globe and constantly endeavours to refine his own unique stock picking approach. While a firm advocate of the principles of value investing, he believes in adapting a versatile investing strategy in response to varying market conditions. Devanshu contributes to our Megatrend investing service The India Letter.

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