 "Have midcap stocks run up too fast, too soon?")
The rally in midcap stocks continues unabated. Over the last three years, the Nifty Midcap 100 is up a stunning 92%, more than twice the Nifty’s 41% rise. In compounded annual growth (CAGR) terms, the Nifty Midcap 100 has delivered a 24% CAGR compared to just 12% for the Nifty. No wonder then, that over the past three years, the midcap schemes of mutual funds have trounced the large-cap schemes. The top-performing midcap schemes have delivered a 32-39% CAGR, compared with just 19-23% for the large-cap schemes. The performance of smallcap schemes has been even better but for the purposes of this post, let’s stick to midcaps.
What is a midcap stock?
There is no universal, standard definition of a midcap stock. But as the name implies, in terms of size, it is between a large cap and a small cap stock. To get an idea of a midcap stock’s size (i.e. market capitalization or the outstanding shares of a company multiplied by the closing market price of its share), let’s consider the Nifty Midcap Free Float Midcap 100 Index, which is the benchmark for many midcap mutual fund schemes. This index is constructed by a process of elimination and does not mention a specific market cap threshold for the stock to be classified as a ‘midcap’. The index is based, among other things, on the free float market cap of the stocks (free float market cap is that part of market capitalization that is not held by promoters and hence available for trade in the market).
As at 30th June 2016, the largest stocks in this index were Bajaj Finance (free float market cap of Rs18,490 cr), JSW Steel (Rs17,082cr), and Bajaj Finserv (Rs14,882 cr). How large are these stocks? To put things in perspective, the largest free-float stocks on the Nifty are HDFC Bank (Rs245,256 cr), Infosys (Rs216,211 cr) and HDFC Ltd. (Rs212,748 cr). As you can see, the midcaps are less than 10% of the market cap of the large cap stocks. Generally speaking, and to round off numbers, a midcap stock should have a market cap of at least US$1billion (or around Rs6,700 cr). Anything less would, generally, be seen as a small cap stock.
How did midcaps become attractive?
As mentioned above, the outperformance of midcap stocks to large cap stocks began three years ago. Rewind to 2013 when the ‘taper tantrum’ had caused turmoil in global markets. Indian markets, in tandem, witnessed a sharp correction, with the Nifty falling to 5119 on 28th August 2013 from 6229 on 20th May 2013 – or 18% in just over three months. With the benefit of hindsight, we can say that fall created the bottom for the Indian stock market. With Raghuram Rajan taking charge at the RBI followed by the BJP’s victory in the 2014 General Elections, the Nifty rallied subsequently.
From that bottom, investors backed midcap and smallcap stocks over large caps. Take the HDFC Midcap Opportunities Fund, which saw a 5x increase in AUMs from 31st August 2013 (Rs2,457 cr) to 30th June 2016 (Rs11,537 cr) – far ahead of the increase in value of its portfolio. This shift towards midcap stocks could have been driven by investors’ belief that an imminent turnaround in the economy would benefit these companies more than the large cap companies. Mid/small cap stocks typically trade at a discount to large cap stocks and three years ago, investors possibly believed that this discount looked attractive.
Can this rally sustain?
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After such a scorching performance, the Nifty Midcap 100 now trades at a P/E of 34x compared to 23x for the Nifty. As the chart below shows, while both indices started at similar valuations last year, the Nifty Midcap now commands a 44% premium over the Nifty.
Source: NSE
This premium is at its highest level in the past year. From here, the midcap index would need major earnings surprises to sustain this premium to large-cap stocks. Alternatively – and more likely – the Nifty could also rally to narrow this gap. Watch out for the ongoing results season for a better idea on both scenarios.
Anupam Gupta is a Chartered Accountant and has worked in equity research since 2000, first as an analyst and now as a consultant. He contributes to the Business Standard platform, Punditry, through his blog, Beyond Markets on markets & the economic horizons.
He tweets as @b50