Loading up on future: Small-and mid-caps turning into an investor favourite

This is the time for investors to pick up quality mid- and small-cap stocks at low valuations. Mid- and small-cap stocks are back on investor radar after falling out of favour for nearly one and a half years in calendar year 2022 (CY22).

The National Stock Exchange Nifty Midcap and the Smallcap indices outperformed the benchmark Nifty50 last month after a gap of 20 months.

For instance, the Nifty Midcap 100 was up 5.9 per cent in April 2023, while the Nifty Smallcap 100 rallied 7.5 per cent last month. This was much better than the Nifty50 which was up 4 per cent during the month.

In contrast, the Nifty Midcap and Smallcap indices had done poorly in CY22. The Nifty Midcap 100 was up 3.5 per cent in CY22, while the Nifty Smallcap was down 13.8 per cent last calendar.

For comparison, the Nifty50 was up 4.3 per cent last calendar.

A poor showing by mid- and small-cap stocks resulted in significant decline in their valuation from their record high in the last quarter. Many quality mid- and small-cap stocks are trading at a significant valuation discount to large-cap stocks. This makes them a value buy at their current share price.

The price movement in mid- and small-cap stocks follows a cycle. There is a rally in large-cap indices such as the Nifty50 and the S&P BSE Sensex and then spreads to mid- and small-cap stocks. Many analysts believe that a good showing by smaller stocks in the last month could be the start of a new rally in mid- and small-cap stocks.

Here are five mid- and small-cap stocks that have the potential to gain the most if this rally sustains. These stocks have been selected based on analyst price targets, the latest annual return on equity, and the company’s revenue and earnings growth in the trailing 12 months.

Coromandel International

• Chennai-headquartered Coromandel International has one of the best financial ratios in the fertiliser industry and a debt-free balance sheet on a net basis
• The company has topped the growth charts in recent quarters, led by higher sales volumes, margin improvement in the fertiliser segment, and balance-sheet deleveraging
• Its net sales were up 60.3 per cent year-on-year during the trailing 12 months ended December 2022, while its net profit was up 47.5 per cent in the period
• Analysts expect the phosphatic fertiliser producer to maintain its growth momentum, backed by efficient sourcing of raw material, product innovation, and capacity expansion 
• On the downside, some analysts expect its earnings before interest, tax, depreciation, and amortisation margin to remain under pressure since the industry has not taken adequate price hikes to cover a broad swathe of commodity prices on the rise

Federal Bank

• Private lender Federal Bank has been one of the top performers in its segment in the past two years
• Its gross interest income was up 16 per cent year-on-year (YoY) during the trailing 12 months ended December 2022. Its net profit was up 49.6 per cent YoY in the period
• Growth was driven by strong double-digit growth in the loan books and a sharp decline in provisions for bad loans
• Analysts expect the Aluva (Kochi)-headquartered bank to maintain its growth momentum, driven by strong credit growth, stable asset quality, market-share gains, and a further improvement in its return on assets (RoA)
• Motilal Oswal expects the bank’s earnings to grow at a compound annual growth rate of 16 per cent over the 2022-23 through 2024-25 (FY25) period with RoA/return on equity of 1.3 per cent and 15.2 per cent, respectively, by FY25
• The stock is trading at a trailing price-to-earnings of 10.2x and a price-to-book value of 1.4x — a discount to the valuation of large private sector banks

LIC Housing Finance

• LIC Housing Finance’s financial performance in the first nine months of 2022-23 (FY23) was adversely affected by sluggish demand for home loans, prompted by a rate hike by the Reserve Bank of India
• Parcelling out individual home loans were down 11 per cent, while total disbursements declined 9 per cent year-on-year (YoY) in the third quarter (Q3) of FY23, resulting in poor top-line growth and a decline in earnings
• The housing finance mortgage loan company, however, reported a pick-up in loan growth in Q3FY23, with its net interest income up 10 per cent YoY and 38 per cent quarter-on-quarter in the quarter
• Analysts at Motilal Oswal expect its loan book and net profit to grow at a compound annual growth rate of 11 per cent and 26 per cent, respectively, over FY23 through 2024-25 (FY25), while return on equity is expected to improve to 13 per cent in FY25
• The stock is trading at a trailing price-to-earnings multiple of 6.7x and a price-to-book value of 0.74x — amongst the lowest in its segment

Deepak Fertilisers & Petrochemicals Corporation

• Pune-headquartered Deepak Fertilisers & Petrochemicals Corporation reported a big jump in its revenue and net profit in 2022-23 (FY23), driven by higher volumes and price realisations
• The company’s net sales were up 45.6 per cent year-on-year (YoY) during the trailing 12 months ended December 2022. Its net profit was up 141.3 per cent year-on-year (YoY) in the period
• The company maintained its growth momentum in the third quarter of FY23, with 41 per cent YoY growth in net sales and 39 per cent YoY rise in net profit
• To maintain growth momentum, the industrial chemical and fertiliser manufacturer is now investing Rs 6,551 crore in capital expenditure to more than double its production capacity by September 2025
• The company announced a demerger plan for its mining chemical and fertiliser businesses that will split the company into a 60:40 ratio as regards revenue
• The stock is trading at a trailing price-to-earnings of 6.1x and a price-to-book value of 1.65x — one of the lowest in the chemical industry

IIFL Finance

• IIFL Finance has been one of the fastest-growing non-bank retail lenders in recent quarters
• Fairfax-backed finance and investment services company’s gross interest income was up 20.5 per cent year-on-year (YoY) in 2022-23 (FY23), while its net profit was up 26.3 per cent YoY in the period
• The company’s total assets under management was up 26 per cent YoY to reach Rs 64,638 crore at the end of FY23, driven by growth in home/gold loans
• The company is now aggressively expanding its presence in the high-yield segment of loans against property, digital lending, and microfinance
• The yield on its loan book was up 180 basis points (bps) YoY to a record high of 16.5 per cent, while gross non-performing assets was down 131 bps YoY to 1.84 per cent at the end of FY23
• The stock is trading at a trailing price-to-earnings of 12x and a price-to-book value of 2x — one of the lowest in the segment

Aditya Birla Fashion & Retail

• Madura Lifestyle Brands, which accounted for over 62 per cent of Aditya Birla Fashion & Retail’s consolidated revenue and operating profit in the third quarter of 2022-23, generates a healthy return on capital employed
• Multiple strategic initiatives like entry into footwear by acquiring Reebok’s India operations, the launch of premium menswear ethnic brand Tasva, and setting up a separate platform to build a portfolio of direct-to-consumer brands will add value over the medium to long term, observes ICICIdirect
• The fashion retail company has strengthened its balance sheet through a recent equity infusion, with net debt declining from Rs 2,500 crore (in 2019-20) to Rs 340 crore. Judicious capital allocation (including acquisitions), however, will be crucial for the company to generate healthy returns
• Further gains will depend upon the company’s ability to execute and hit its revenue target of Rs 21,000 crore and operating profit of Rs 2,350 crore by 2026

Sun TV Network

• While there were headwinds owing to lower advertising (ad) spends by key segments, implementation of the New Tariff Order 3.0, and issues with multi-system operators, advertising revenue growth is expected to improve gradually in 2023-24
• Brokerages estimate a high single-digit growth, led by Sun TV’s steady viewership in the Tamil market, improvement in ad spends, and election-related expenditure in the second half of 2023-24
• After removing Indian Premier League (SunRisers Hyderabad) and cash, the core business trades at an attractive 3.6x its one-year forward price-to-earnings multiple, says IIFL Research
• Given the over Rs 5,000-crore cash on the balance sheet, the dividend payout ratio could remain high

VIP Industries

• The leader in the organised luggage industry with 44 per cent share is expected to be a key beneficiary of the 15 per cent annual growth for the sector and the shift to branded luggage and shorter replacement cycles
• Travel having returned swiftly and marriage demand remaining robust (the two segments account for 90 per cent of demand), coupled with offices reopening, should aid company growth
• A balanced approach between maintaining revenue and margins (premium category tilt) has helped the company double its margins over the past eight years, with nine months of 2022-23 profitability at 15 per cent. The company seeks to take this up to 20 per cent
• The shift to local manufacturing, softening raw material prices, and international expansion augur well for the company, observes Anand Rathi Research

Balaji Amines

• Solapur-headquartered specialty chemicals company is one of the largest manufacturers of aliphatic amines and their derivatives through indigenous technology that keep manufacturing costs low
• Although its operating profit margins fell sharply in the October-December quarter of 2022-23 (FY23) on the back of weak realisations, stable raw material costs and higher contributions from new facilities will help improve margins from the April-June quarter of 2023-24
• The company has a capital expenditure plan of Rs 400-500 crore over the next three years and its focus remains on products with limited competition/import substitution/higher value addition
• Although the company is expected to end FY23 with a revenue of about Rs 2,300 crore, the management is eyeing revenue of Rs 4,000 crore by 2024-25 on the back of incremental volume, increased utilisation, and new capacity addition. Margins are expected to be maintained in the 25-26 per cent range

GMM Pfaudler

• Karamsad (Gujarat)-headquartered supplier of process equipment is the market leader in corrosion-resistant glass-lined (GL) equipment used in pharmaceutical and chemical industries
• While sequential margins in the October-December quarter of 2022-23 were down 30 basis points to 14.9 per cent, the company expects profitability to improve on lower raw material costs, improved pricing on new orders, and a better product mix
• Investments in specialty and agriculture chemicals are expected to drive domestic business, while improved order inflows should support international business. The company has stuck to its revenue growth guidance of 13 per cent over 2021-22 (FY22)-2024-25 (FY25) and reached a revenue of Rs 3,700 crore by FY25
• JM Financial Research expects sales to grow 14 per cent, while earnings growth is likely to grow 32 per cent over FY22-25 on the back of scale-up in non-GL segments, new acquisitions, and steady improvement in margin profile