History suggests while largecaps kick off a rally, it is the midcaps that lead the show at least in the first year of recovery.
Midcaps with positive free cash flow, earnings growth expectations in excess of 15 per cent for the subsequent year and a stock price drop of at least 15 per cent in the previous 12 months are the ones that have historically rallied the most in the year of market trend reversals, suggests a study by Edelweiss Securities.
From a 50 per cent premium to Nifty, midcap valuation as suggested by Nifty Midcap100 is now at a 20 per cent discount, similar to that in 2011, which offers comfort on the downside, said analysts.
“What midcaps were lacking was confidence and risk aversion. A fresh step from the government has removed risk aversion to some extent. If you see some earnings coming back over time, there is definitely a case for midcaps to outperform from here on,” said Gautam Duggad, Head of Research at Motilal Oswal Securities.
Only one-third of Nifty Midcap100 stocks are now trading above their January 2018 levels, data compiled by corporate database AceEquity suggests. For 33 worst-performing BSE Midcap stocks to revisit their January 1, 2018 levels, they need to rally anywhere between 50 per cent and 272 per cent!
History bats for rebound
In last 13 years, the midcap index has never underperformed the largecap index for more than a year. After 2013’s poor show, the midcap index rallied 54.7 per cent in 2014, which was better than Sensex’s 29.9 per cent surge.
Calendar years 2012 and 2009 saw the midcap index jump 38 per cent and 107 per cent, respectively, after years of poor returns.
This year, the NSE Midcap100 index is down 8.8 per cent in the first nine months, compared with a 7 per cent rise in Sensex.
At Rs 15 lakh crore, the absolute market-cap of Nifty Midcap100 is down 31 per cent from its January 2018 peak of Rs 22 lakh crore. It is also below the December 2014 high of Rs 16.7 lakh crore. The top 30 midcap stocks by weight fell a mere 2 per cent during this period against a massive 29 per cent drop in the remaining 70 constituents. This trend is similar to the divergence in performance seen between the top 15 Nifty stocks and the rest.
Analysts see buying opportunities in many midcap stocks. “Typically, the spread between largecap and midcap returns has peaked out at 15-20 per cent. After hitting this peak range, the performance has typically reversed in the past. At present, this spread is at 14 per cent. Also, the average difference in the peak-to-bottom correction between Midcap100 and Nifty has been 14 per cent. In the current episode, this difference is at 31 per cent, which is the highest since 2006,” Motilal Oswal Securities said in a strategy note.
What to watch?
Edelweiss Securities said while the correction in midcap stocks has been led by a fall in valuation multiples, earnings downgrade has only been mild.
In June quarter earnings, midcap stocks fell 5 per cent against the annual consensus estimate of 15 per cent growth, which entails 20 per cent growth in the rest of FY20.
“Two-thirds of the midcap100 stocks have seen earnings cuts of less than 15 per cent in last one year. This signals some more earnings cut ahead. It also shows this space is not a blanket buy yet,” Edelweiss said.
Within the midcap space, sectors including financials may find favour as their RoEs expand by 100 to 200 basis points following the tax cut, says Duggad of Motilal Oswal. Midcaps from consumption or consumer discretionary segments may also see some buying.
“You will not see midcaps with stress on balance sheets or lack of earnings visibility perform. Clearly, midcaps can outperform as a pack from here on,” he said.
Stocks to consider
Foreign brokerage Morgan Stanley, which expects midcaps to outperform largecaps, is bullish on Indian Hotels, Jubilant Foodworks and M&M Finance. It also likes MCX, Shriram Transport, Ashok Leyland and Container Corp.
Antique Stock Broking likes Honeywell Automation, TVS Motor, Federal Bank, Gujarat Gas, Phoenix Mill, Natco Pharma, Kajaria Ceramics, Nalco, Timken India, MOIL and Dhanuka Agritech from the midcap space.
Motilal Oswal Securities prefers Indian Hotels, Federal Bank, MMFS, Ashok Leyland, PI Industries, ABFRL, JK Cement, Oberoi Realty, Colgate Palmolive and Alkem Labs.
Edelweiss likes 22 midcap stocks such as Info Edge, VIP Industries and AU Small Finance. Here is the complete list.
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