Midcap  froth clearing, but caution remains

“The valuation premium gap between midcaps and largecap stocks has now narrowed. With that, a lot of froth in the midcap segment has cleared,” said Sahil Kapoor, head of products and market strategist at DSP Investment Managers.

During periods of heightened economic uncertainty, which has generally been the case this year, investors flock towards safer options. One example of this is choosing largecaps over midcaps. The looming risks of a global recession and elevated inflation have pushed investors to shuffle their portfolios from midcaps to largecaps, given the latter’s better pricing power to weather the cost inflation storm. Also, midcaps with higher leverage could come under pressure in a rising interest rate scenario due to their comparatively lower ability to raise funds to service debt.

“We saw FII inflows during the months of July-August; at that time, we saw FII money chasing largecaps, which is not surprising given the better liquidity in these stocks compared to the mid- and small-cap stocks. At that time, the valuation premium gap between largecaps and midcaps also saw a reduction,” said Deepak Jasani, head of retail research at HDFC Securities Ltd.

View Full Image

Of course, a crucial factor that gives largecaps an edge over midcaps is their relatively stable earnings performance. While commodity cost inflation has been a pain for all, midcaps have seen greater adverse impact leading to a disappointing earnings performance in the September quarter (Q2FY23).

An analysis of stocks in the Nifty Midcap 150 index by Nuvama Research showed that in Q2, more than half of stocks in this lot missed estimates on revenue, Ebitda and net profit.

Little wonder then that FY23 and FY24 earnings estimates for midcaps have been trimmed. In fact, the trend in earnings upgrades versus downgrades for these stocks further paints a grim picture. Data for the past seven quarters shows that upgrades trend is slowing down (pace and quantum) while downgrades have risen, said the Nuvama report.

What compounds the problem is that despite their poor earnings performance, earnings growth expectations are running high. “Nearly 80% of the stocks within Midcap 150 have FY24 earnings growth expectations, which are higher than the earnings growth that these companies delivered during FY19–past four quarters,” points out Nuvama.

To be sure, the US Fed is still not done with its rate hike spree and that’s a risk for midcaps. Nevertheless, some lost ground could be recovered in the foreseeable future. “In the very near term, as the year draws to close, we expect midcaps to see a catch-up rally. Given their underperformance to largecaps so far in this year and moderating valuations, the counter may see some buying interest,” said Nishit Master, portfolio manager at Axis Securities Ltd. On the flipside, a reversal in domestic institutional inflows, which does not seem likely currently, could be a downside risk for midcaps, he cautioned.

But that’s not all. Further, a risk to recovery in midcaps also stems from an uneven economic recovery where domestic demand at rural level is still patchy, cautioned Kapoor.