Are mid, small cap indices really that expensive?

Mid- and small-cap stocks have been outperforming frontline stocks ever since the market rebounded from the March 2020 lows. The BSE Midcap index and BSE Smallcap index have surged 133% and 183% respectively in this time, even as the BSE Sensex gained 103%. This sharp uptick in the broader market has sent index valuations to lofty heights. But are these names really as expensive as valuations suggest?After the surge of the past 15 months, the mid-cap and small-cap indices are now trading at rich valuations. The sharp re-rating even suggests the normal discount relative to large-caps has vanished. “We do believe that the relative PE discount has eroded, leaving mid-cap valuations at similar levels to large-caps for almost similar earnings growth over the next two years,” insists Neelesh Surana, CIO, Mirae Asset Investment Managers India.However, some analysts are convinced that the index valuations are not painting a true picture. “Headline PE valuations of mid-and small-cap indices are significantly distorted as they currently have significant loss pools thereby optically magnifying the numbers,” observe analysts at ICICI Securities. At the same time, large-cap index loss pools have moderated significantly— further distorting the relative valuation picture. For 2020-21, the NSE Smallcap 100 index witnessed the loss pool amounting to 53% of the aggregate profit base, while in the mid-cap space, (NSE Midcap 100) the loss pool contribution was 42%. Meanwhile, the Nifty50 index saw a contribution to loss pool of merely 2% for the same period.Current earnings yield for mid-and small-caps no longer very attractive 84087854How do companies with losses disturb the index valuation? The index PE is calculated on the base of total earnings. A large pool of loss-making companies depresses the aggregate earnings for the basket. Meanwhile, the index price continues to incorporate stock price of all companies in the basket, including the lossmaking ones. This artificially props up the index price relative to the index earnings, giving illusion of higher PE. “Introducing such companies into aggregate index level calculations can completely distort the picture especially if the loss pools are significant,” argue analysts at ICICI Securities.Pankaj Tibrewal, Senior Fund Manager, Kotak Mahindra AMC, says, “A better way is to compare earnings yield of profitable companies of all indices. There we observe that though the earnings yield spreads of mid-caps and small-caps vis-a-vis large caps have compressed significantly over past one year, it has still not reached the extremes seen in 2017.” Earnings yield is the inverse of the PE ratio. ICICI Securities points out that large-caps have a trailing earnings yield of 3.5% while mid-and small-caps continue to yield more at 4.2% and 4.5%, respectively. Yields of mid-and small-caps over large-caps turning negative typically coincides with the peaking of the former basket. The last time spreads were negative was in December 2017—on the back of sharp run up over the previous two to three years. For two years thereafter, mid-and small-cap stocks underperformed large-caps sharply.The distortion created by earnings in relative valuation is evident in the reading of other valuation metrics. The PBV or price to book value metric gives a slightly different picture. While the bellwether BSE Sensex index trades at 3.4 times PBV, the mid-and small-cap index counterparts are trading marginally lower at 3.14 and 3.21. Clearly, the valuation gap with large-caps still persists, even if it is smaller than before.To be sure, the sharp turnaround since last year has clearly taken away much of the risk-reward in mid- and small-cap names. Experts maintain that investors need to tread with caution in this space now. Tibrewal asserts, “Mid- and small-caps had a great run in the past 15 months. After the strong rally, the valuations in this basket are no longer cheap as it was during the March 2020 crisis and so one should be cautious in the near term.” Analysts at ICICI Securities note that managing risk becomes paramount while investing in the broader market, and investors should steer clear of speculative stories which are not supported by adequate earnings yield, growth prospects and quality of business. This has become critical especially post the significant outperformance since 2020 which has taken away a significant amount of ‘margin of safety’ from mid-and small-caps. Ideally, investors should invest through equity funds in the mid-cap or small-cap space. Further, the amount should preferably be deployed through the SIP mode with a time horizon of at least seven years to tackle intermittent volatility.

from Economic Times https://ift.tt/3hj2UyW