Mid-caps back in favour as valuation discount widens

India may be the most over-researched market in the world. But one thing is for sure, there are still plenty of stock opportunities that have so far remained away from the limelight and thus unexplored. There’s a majority view among experts that it’s this select less-tracked mid-cap and small cap stocks which stand to gain from the economic upturn ahead.

Brokerage firm Espirito Santo Securities throws more light on it. “Three of the top five most covered companies in the world are in India and five of the top five most covered companies in Asia are in India. As clients are quick to remind us, the sell side is far from always right in its stock recommendations, but it is hard to argue that this level of over researching of stocks helps in the search for new insights on the market and hence, for finding alpha (excess return creation opportunity),” wrote analysts Nick Paulson-Ellis, Aditya Jhawar and Nitesh Sharma, in a strategy note dated April 30.

The trio at Espirito Santo believe that while the biggest stocks in India have hogged all the spotlight, mid- and small caps have been given a short shrift so far – the coverage drops away quickly as you move down the curve. “We think high-quality smaller companies often trade at meaningfully lower valuations than merited, leaving alpha available for investors willing to move down the liquidity curve,” they wrote.

Similarly, Morgan Stanley Investment Management had written about this funnel-type research coverage in India where the sell side analysts track nearly 578 stocks, but nearly half of them are covered by less than 10 analysts.

“There are only 51 stocks in the world that are rated by more than 50 sell-side research analysts. Of these, 49 are in India. The only two stocks outside India are Apple and Intel,” wrote Amay Hattangadi and Swanand Kelkar, portfolio managers at Morgan Stanley Growth Fund.

Analysts feel mid- and small caps that have outperformed large caps long term are currently available at attractive valuations. Espirito Santo hammers this point in, saying that in India,  the 10-year compounded return of CNX Midcap has been 23% as against 20% for the Sensex. Also, the four listed companies with 60%+ CAGR returns in the last 10 years have been all mid-sized firms. The number of mid-sized firms that provided 50%+ CAGR returns in the last decade is nearly 4.5 times the number of large caps,” they wrote.

Gaurav Mehta of Ambit Capital sees this valuation discount of small caps to large caps at multi-year highs currently and feels historically such high discounts have been corrected by broad-based market rallies. While the Sensex is just 5% off its all-time high, for small caps and mid caps, it’s 54% and 13%, respectively. The Espirito Santo analysts are clear about the direction for investors: they want them to look at mid-cap firms with right business, economic moat, and the right management team, low levels of pledging, sound balance sheets and no major governance issues.