The recent correction in the Midcap Indices has created a lot of disarray in portfolios. While the Sensex and Nifty have fallen just 3.43% and 4.46% respectively from their all time highs of 36,283 and 11,130 reached on January 29, 2018, the BSE small cap and midcap indices are down nearly 19% and 15% from their all time highs . Even now, a large amount of Midcap stocks trade at almost double the PERs of Nifty and that gives rise to discomfort.
The obvious question – whats next!
The Genesis of the Fall
Midcaps have had a marvelous run since January 2016 which is when the outperformance over largecaps started and finally peaked in January 2018 post which largecaps have outperformed.
A lot of factors have contributed to this relative underperformance including :
- The earlier flows could have also been due to the demonetization move which led to money flowing into equities which eventually found their way into midcaps – combined with mutual fund flows, this led to the creation of some major froth – with most Midcaps trading almost at 40x-60x PER valuations which had to correct sooner or later.
- The imposition of long-term capital gains tax and a dividend distribution tax of 10 per cent on equities from April 2018
- The period from 2013 to 2016 was one with low commodity prices and benign interest rates – both cycles have reversed in the last 6 months as metals such as Copper hit 4 year highs last week and crude is touching 80 USD /bbl. These price movements negatively impact multicaps more than largecaps in a wide variety of ways
- The recent reclassification of largecap, midcap and smallcap stocks followed now by the newly introduced additional graded surveillance mechanism as well as higher margins on derivatives have all led to liquidation pressures.
- Globally, interest rates are likely to go a little bit higher in the next 12 months as the world’s central banks tighten rates. Indian bond yields crossed 8% , highest in 3 years in the previous week and are likely to remain on a higher base. That will act as a cap on equity prices globally as well as in India as balance sheets adjust to new realities.
- The move towards a very “nationalistic” approach , led by President Trump’s imposition of duties etc will have capacity disruptions which end up impacting export oriented sectors and more so in the smaller capitalization space.
Also one needs to remember that it’s an election year and pre poll alliance related rumours are likey to cause volatility here and there all along until growth becomes strong enough to counter these.
The consensus currently is that there is a high probability of high growth returning over the next two – three quarters which will feed into the midcap sector and bring the PE ratios to a more acceptable level at which stage more aggression may return all over again. US growth is on a strong pitch and it is likely that this will feed into global market demand and with a depressed rupee, profitability may come back on track for export oriented sectors. Domestic growth is likely to remain above 7% and will likely continue to support locally oriented enterprises.
Given that Indian flows have become mutual fund dominated (read stable) , this concoction of variables implies that select quality Midcaps will recover faster than the segment as a whole.
Unlike earlier, investors seem to be more patient and each decent correction is bringing back interest into equities as is also evidenced by the return of almost USD 2 Bn equivalent inflows in May 2018. HNIs are looking to redesign and add to portfolios in recent times unlike previous decades.
We have been recommending a largecap orientation right from January 2018 to our clients and believe this strategy has worked well –and continue to maintain the same stance.
Technically speaking, the Midcap underperformance over Largecaps may continue for some more time and further corrections after brief rallies are not ruled out before real value emerges.
There are great reasons to be in Indian midcaps from a 5 year perspective hence any corrections will present opportunities for the bravehearts- PL Research (See our current Midcap and Small cap ideas at https://www.plindia.com/LatestReports.aspx) will keep clients abreast of its latest recommendations and do write in to us at email@example.com for opinions on your portfolios and possible rotation opportunities.