Large vs midcap stocks: Which theme should investors choose in the election year?

stocks

Similar to a political party seeking a coalition in case of failing to get a full majority, an investor should form a coalition of quality large and midcaps to achieve financial goals

Investors are not only finding it difficult to predict who will win the ongoing Lok Sabha election but are also unsure about which of the two themes to select — large or midcaps — for FY20.

After suffering double-digit losses in FY19, most investors are reluctant to even touch mid and smallcap stocks. The Nifty Midcap and Smallcap indices contracted about 5 percent to 15 percent in FY19 led by liquidity crisis witnessed after IL&FS fiasco and issues pertaining to corporate governance.

However, CY19 so far has been a better year for broader markets but both mid and smallcap indices are still down over 10 percent each from their respective highs, which, according to experts, have made valuations slightly attractive.

The S&P BSE Midcap index is trading at PE of 31.32x and a price-to-book value of 2.67 while the S&P BSE Smallcap index is trading at a negative PE of -169x, or in other words, it means negative earnings. The S&P BSE Largecap index has a PE of 26.37x and a price-to-book value of 3.01, according to BSEIndia.com.

Earnings across market capitalisation will continue to see improvement, said experts, adding that mid and smallcaps have a marked difference in the quality of their balance sheets compared to three years ago.

“The debt levels in the balance sheet have come off and they present a far stronger balance sheet than what it used to be. With utilisation levels picking up and cleaner balance sheets, one can expect decent growth in revenue and profits for the mid and small-cap companies,” Aniruddha Naha, Senior Fund Manager-Equity, DHFL Pramerica Asset Managers Private Ltd told Moneycontrol.

“Deep correction in mid & smallcaps and stronger earnings visibility to mean good times for broader market companies over the next three years,” he said.

Elara Capital expects earnings expansion in midcaps to be meaningfully high over the next two fiscal years as well. The Nifty midcap consensus EPS CAGR for FY19-21 is at 22.4 percent, which provides strong fundamental support, it said.

“The Nifty Midcap 100 EPS growth that incorporates for PSU bank earnings bounce back in FY19, looks steep (YoY EPS growth of 97 percent) but on an ex-fin basis, FY19 earnings growth stands at 25 percent and the FY19- 21 earnings CAGR is expected to be around 12 percent,” it said.

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Largecaps will continue to attract more money but midcaps could offer big capital appreciation, going by expert commentary. If someone is willing to take that risk, midcaps become a strong contender for your portfolio in FY20.

According to Karvy Stock Broking, mid and smallcaps tend to perform better – 1) when the market is in risk-on mode; and 2) when valuations are favourable

In last one year, midcaps have traded at a premium of 12 percent to Sensex in terms of the 12-month forward PE ratio.

When the midcap index is at a discount, they tend to outperform sharply. Typically, the discount is the result of a correction in mid and smallcaps after a risk-off scenario.

“Currently, the midcap index is at par with the Sensex, below the historical average premium of 12 percent. This implies that one of the two conditions (that is underperformance) for midcaps and smallcaps to do well exists. We believe that market participants are willing to take more risks,” said the Karvy report.

“The conditions for mid and smallcaps to outperform are thus falling into place. We believe that over the next 12 months, mid and smallcaps are likely to perform well,” it said.

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