Valuations of midcaps, smallcaps rich, outperformance against largecaps may not continue, says Nuvama

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The brokerage firm highlighted that SMID (small and midcaps) indices have surged 40-50 per cent this year, outperforming large caps by over 25 per cent. It believes valuations now look stretched from all perspectives.

“Since Mar-23 specifically, Midcap and Smallcap indices are up 47 per cent and 61 per cent, respectively, outperforming Nifty 50 by 27 per cent and 41 per cent, respectively. Especially the Smallcap valuations (one-year forward PE is more than 20 times) look quite stretched (compared to the long-term average of fewer than 15 times and now at a premium to Nifty valuation versus a long-term average discount of 15 per cent),” Nuvama said.

“Given the high mortality rates that smallcaps see (only about 10 per cent of the smallcap become midcap over a five-ten year period, the rest remain smallcaps or become micro-caps), we believe that smallcaps are in a vulnerable zone now,” said Nuvama.

Also Read: Nifty 50, Sensex at record highs; how should you play large, mid, smallcaps?

Nuvama underscored that midcaps are also expensive but they should still do relatively better than smallcaps.

“Midcaps are also expensive at 26 times P/E (versus 20 times 10-year average), but the sizes and profiles of midcap businesses in India have improved significantly in the past five–seven years. Midcap premium of 28 per cent to Nifty valuation (versus 7-8 per cent average) is also not supportive. Hence, we think outperformance versus large caps hereon is highly unlikely. In a turn of events (market decline) though, midcaps are unlikely to do as badly as small-caps,” said Nuvama.

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However, despite the segment’s rich valuations, the brokerage firm pointed out that historically there have always been pockets of growth, favourable dynamics and stock performance.

Also Read: JM Financials upgrades Tata Power to ‘buy’ after shares hit 52-week high, sees 24% upside over revised TP

Nuvama said the size of Indian midcaps now gives more comfort.

From the beginning of the calendar year 2024, Nuvama estimates that the midcap market cap definition will be $2.8-8 billion (applicable to domestic mutual fund midcap schemes). This is a sizeable jump from the $1.2-3.5 billion, just four years back.

Nuvama said that the higher market cap range potentially increases the likelihood of the first 50-75 midcap stocks being treated as large caps by investors, and hence midcap drawdowns are unlikely to be as drastic as seen in history. Moreover, midcaps have had a good track record in terms of becoming large caps.

“Our data shows that over time, while one-third of midcaps remain midcaps, a commendable 33-37 per cent of the midcaps do graduate to become large caps over a 5-10-year period. In effect, the mortality rate is much lower and conversion to a higher category is superior for midcaps than small-caps,” said Nuvama.

Also Read: Budget 2024: Govt will continue to incentivise manufacturing and infra, says Nimesh Chandan of Bajaj Finserv AMC

Within the SMID coverage, Nuvama said it looks for value, which it defines by (i) poor business performance thus far, but a turn of events on the cards, (ii) weak stock performance, (iii) valuation below historical averages and peers, (iv) majority of the earnings downgrades having played through, and (v) improvement or upside triggers in place.

Also Read: Budget 2024 may be balanced; NDA’s win in 2024 may not trigger any sharp rally, says Ashutosh Tiwari of Equirus

Top picks

“Our stock picks here are: Crompton Consumer, Exide, PI Industries, Blue Dart, Vijaya Diagnostics, Lemon Tree, JSPL, Coforge and Sapphire,” said Nuvama.

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Disclaimer: The views and recommendations above are those of individual analysts, experts and broking companies, not of Mint. We advise investors to check with certified experts before making any investment decisions.

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Published: 08 Dec 2023, 09:39 AM IST

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