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Stocks of mid-sized companies continue to outperform the large-cap players causing valuations in the mid-cap stocks to soar.
Even in the current month when the benchmark BSE Sensex declined by over 5%, the BSE mid-cap index was down by 3%. But analysts believe that the outperformance may not continue in 2015, citing fears that an earnings turnaround may take longer than expected.
The price to earnings ratio on a trailing 12-month basis for the BSE mid-cap index is over 22 times compared to 17 for the BSE Sensex. The valuations differential has widened as the former has outperformed the benchmark index by a huge margin this year.
The BSE mid-cap has given returns of about 45% so far this year compared to the 27% returns given by the benchmarks, NSE Nifty and S&P BSE Sensex. Some of the stocks in the mid-cap segment have risen by up to four times.
Market-men believe that the rally in the mid-cap sector is largely on the back of euphoria and less to do with fundamental changes. Any meaningful change in the mid-cap companies' earnings is still a few quarters away, they said.
"There is a bubble in a lot of mid-cap stocks. Plenty of stocks in that space are quoting at valuations over 30 times. Some stocks are even commanding higher premium than sector leaders," said G Chokkalingam, founder of Equinomics Research and Advisory.
Market players say sharp surge in stocks in mid-cap segment is drawing more retail investors, typically the ones wanting to make quick buck. But without on the ground changes, many analysts say the rally could be difficult to sustain with little room for further expansion in valuations.
"Investors also need to watch out for low liquidity and high volatility", said Mayuresh Joshi of Angel Broking. "If the free-float is low, then volatility in such stocks will be high. Liquidity in general in these stocks is lower and investors need to keep in mind the impact cost before investing in some of these stocks," he said.
Analysts said that investors need to exercise caution and not blindly chase returns as it might be a while before earnings in many of these companies catch up with the stock prices.
"Just because valuations are looking attractive should not be reason enough to start investing in these stocks. Investors should judge on a case-to-case basis, check for promoter-holding, earnings expectation and the free-float of the company among other things before investing," said Joshi.
Valuations in many of the healthcare and technology sectors are a bit more stretched while those in the financial and infrastructure sectors are comparatively cheaper, analysts said.
However, some in the market believe that the upside could be capped going forward as the market euphoria gets contained as sentiment is likely to remain subdued given the global growth concerns.
"The outperformance that we saw in the mid-cap segment in 2014 is not expected in 2015. Eventually expectations will get tempered down and we will see some correction in these stocks," said Sunil Jain, VP-equity research with Nirmal Bang Securities.
The capex cycle is yet to revive, distribution channels remain weak, gross capital formation is languishing and interest rates are still above comfort-levels further stalling capital expansion by some of the companies.
While a rating upgrade has already happened for many of the companies, analysts believe that real increase in earnings would be seen only from 2016 onwards, analysts said.
