The outlook for the mid-cap rally

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Mid-cap and small-cap stocks are on fire. The S&P BSE Mid-cap index is at an all-time high and the S&P BSE Small-cap index is close to an eight-year high. But note that in the 10-year period between 2003 and 2013, these two indices had produced fireworks often, only to revert to the mean subsequently (see chart).

Will the rally this time around be different? Already, since January this year, the mid-cap and small-cap indices have lost some steam in terms of their relative performance vis-à-vis the S&P BSE 100 index. They have underperformed by 1.4% and 7.3%, respectively, since 8 January.

Valuations of quite a few mid- and small-sized firms have gone through the roof, and it makes sense for investors to be cautious. For instance, Bajaj Finance Ltd now trades at 5.2 times its estimated book value for fiscal year 2017, far higher than even HDFC Bank Ltd, which trades at around 4 times book.

In a report dated 8 June, analysts at Kotak Institutional Equities wrote, “Lending is easy, recovering harder… We note that the market had been quite prompt to award the rapid growth in assets of banks over the past few years, only to regret it later.” Investors tend to be myopic during rallies, and this quirk is being reflected in the valuations of some stocks. Shree Cement Ltd, which was a mid-cap stock not too long ago, now has a market capitalization that’s far higher than that of ACC Ltd and Ambuja Cements Ltd. What’s more, its enterprise value per tonne of capacity works out to around $310, according to Kotak Institutional Equities’ estimates. Market leader UltraTech Cement Ltd gets a valuation of around $215 per tonne of capacity, while in the case of Ambuja Cements, the valuation is below $200 per tonne.

Now both Bajaj Finance and Shree Cement are well run firms, and have performed better than peers in terms of growth and other financial parameters. Even so, valuations are pricing in these positives, and much more.

According to the head of research at a multinational brokerage firm, the fortunes of a number of large-sized companies depend on global factors more than on local factors. Some of these companies have made large global acquisitions, while for some their pricing is dependent on global commodity prices. For some others, exports form a large proportion of revenues and profit.

As such, it is the mid- and small-sized firms that really offer a relatively pure India play for investors. Considering that free-float is typically low in these stocks, increased investor interest quickly results in steep valuations. A number of investors also believe that India is on the cusp of a recovery, and small-sized firms do far better in terms of growth in such phases. Because of their relatively small size, they gain far more on account of operating leverage.

And since these firms are the ones that directly compete with the informal and unorganized sector, they would be far bigger beneficiaries of the implementation of GST (goods and services tax).

All told, there are a number of legitimate reasons why small firms can do far better than their larger counterparts in the near future. However, given where valuations of some of these stocks already are, investors appear to have thrown caution to the wind. If things don’t play out as expected, it would just be another case of reversion to the mean.