After a sharp fall for over a year, valuations in this space have become attractive
The midcap and smallcap indices are likely to turn corner after witnessing a steep fall for over a year with optimism returning to broader markets in recent sessions, according to reports by brokerage firms.
In a report by Motilal Oswal Financial Services, the broad underperformance of the midcaps is overdone and interesting bottom-up opportunities are now available in this space across the sectors.
The large and midcap indices have shown sharp polarisation in their respective performances in the recent past. The big has become bigger, while the small has shrunk further, the brokerage said in its report.
The meager returns of Nifty since December 2017 have been disproportionately led by a set of megacaps and defensives, reflecting the street's tendency to hide in quality in times of tepid earnings delivery.
The broader 50-stock NSE Nifty has delivered 3% returns since December 2017. While this is largely driven by top 15 Nifty stocks (65% of Nifty market cap), which are up by 16% over this period, the other 35 stocks are down by 16%, the Motilal Oswal report added.
The report further said the relentless underperformance of midcaps can largely be attributed to their unsustainable valuation premium to largecaps, macro headwinds, concerns about governance/liquidity issues, and the lack of pick-up in earnings growth.
Referring to its midcap and smallcap universe, Motilal Oswal in the report said that over FY12-18, it had an extremely volatile ride, culminating into a 43% year-on-year profit decline in FY18. The steep fall in PSU banks in the midcap space impacted the broader performance of the universe in 2018. However, given the rebound in the asset quality metrics of PSU banks and the consequent reduction in provisioning costs, the profits for this index are expected to recover significantly in FY19 with 91% y-o-y growth. For the universe ex-PSU banks, growth in FY19 is expected at 16% vs 12% in FY18. Return ratios are also expected to normalise over the next two years.
An analysis of the historical differential of the trailing returns of the Nifty and the midcap index throws an interesting insight, according to the report.
"Typically, the spread between largecap and midcap returns has peaked out at 15-20%. Post hitting this peak range, the performance has typically reversed in the past. Currently, this spread stands at 18%" it said.
In another report, B&K Securities said the smallcaps on an average (based on the BSE SmallCap index) have underperformed their largecap peers by almost 40% over the last 13 months.
The general view, according to the report, seems to be that this underperformance will continue at least till the elections.
"We believe that the major part of the underperformance is over and it is time to increase the allocation to smaller stocks in one's portfolio," it said.
The report said that the ratio of the Smallcap BSE Index to the BSE Sensex has been a good indicator in the past and it shows that when the underperformance 1 standard deviation below its mean, it does not fall much beyond that.
"The Relative performance of smallcaps depends on how the economy is doing. And many indicators are suggesting that the economy is turning around. Even the risk factors of economic growth seem to be in control. The valuations of the smaller stocks have also corrected in this fall and are much more attractive," B&K Securities said in its report.
TIME FOR A TURNAROUND
- Large and midcap indices have shown sharp polarisation in respective performances in recent past
- Given the rebound in PSU banks, profits for smallcaps are expected to recover in FY19
- BSE SmallCap index have underperformed their largecap peers by almost 40% over the last 13 months
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