It’s time to book profits in mid and small-cap stocks & increase investment in large-caps

Last week, the Reserve Bank of India (RBI) warned of a bubble-like situation in the Indian equity market. According to the central bank, the stocks are overvalued in relation to the underlying economic health of India and corporate earnings.

While some investors, especially those on the bullish side of the spectrum, described RBI observation in its annual report for FY 20-21 as alarmist and worth ignoring, for many others the warning could not have come at a better time – in the middle of the second wave of COVID19 that that has proved to be far more deadly and disruptive than the first wave of infection in 2020.

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Worse still, the second wave has broken the expectation of a steady recovery in India's GDP growth and corporate earnings in FY22 from the sharp cuts in the March to July last year due to the first wave.

The equity market has however not taken much note of the potential downside from the second wave and the lockdown enforced across the country to slow down the transmission of infection.

The risks, including overvaluation

The benchmark BSE Sensex is up 9 percent since the beginning of the current calendar year and has rallied 12.1 percent since the lows it hit in January this year.

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This makes it expensive given the downside risk to India's GDP growth and corporate earnings in FY22 due to the second wave.

The Sensex has however proved much more resilient in the past than the underlying economic and corporate fundamentals. And there is a possibility that it may again do so given the benign liquidity globally and strong buying interest from the foreign institutional investors that are real drivers of the stock markets in India.

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This is largely due to the disproportionately faster rise in the mid and small-cap index than in the large cap index.

The BSE Mid-Cap index for example is up 24 percent year-to-date and 48 percent since the beginning of January 2020. The Small-Cap index has done even better. It’s up 32 per cent year-to-date and 74 percent since January 2020.

In other words, mid-cap investors made twice the money that of large-cap investors in the last 17 months while small-cap investors have been 3X better than large-cap investors.

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Market analysts say that such a big divergence in performance is not sustainable. Over a period of 4-5 years, the market follows a cycle where in large-cap or Sensex stocks move first followed by mid and small-cap, while large-cap underperform. But then the market heats-up, smaller stocks are first correct followed by large cap and index stocks.

Besides, the post-pandemic expansion in valuation has been far higher in mid and small-cap space than in Sensex. So if Sensex valuation has expanded by 15 percent post the pandemic, BSE Mid-cap index valuation is up by 35 percent while its up 50 per cent in case of BSE Small-Cap index.

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BSE Mid-cap index is currently trading at 48 times its trailing earnings, nearly 50 per cent premium to the Sensex. The Small-Cap index is even pricier at 53X.

But there is no fundamental basis to give higher valuation to smaller stocks as their earnings growth has not been faster than Sensex companies. In fact, Sensex underlying Earnings Per Share (EPS) is now 5 per cent higher than its EPS at the end of January 2020, but it’s still down 14 per cent in case of BSE Mid-Cap index. There is no comparative number for the BSE Small-Cap index.

Given this, quite a few analysts now expect the rally in the mid and small-caps to slow down and even turn into a correction. They suggest that investors should realign their portfolio to take advantage of this cyclical shift in the market.

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Either way it’s time to book profits in your mid and small cap portfolio and deploy that money in the large-cap space.

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The index stocks are also better placed to absorb the economic disruption from the second COVID19 wave compared to the smaller companies. In fact, nearly a quarter of the Sensex earnings come from companies with substantial global revenues and profits least impacted by COVID19 slowdown in the Indian economy. This could mean that Sensex in particular and large cap stocks in general may outperform mid and small-cap stocks over the next 12 months.

As a thumb-rule, large-cap and index stocks popular with large institutional investors such as insurance companies and FIIs should now comprise at least 50 per cent of your portfolio. Don’t exit mid and small cap space altogether, just go underweight on them.

Happy investing.

(Advice: This article is for information purpose only. Readers are advised to consult a certified financial advisor before making investment in any of the funds or securities mentioned above.)

(Karan Deo Sharma is a Mumbai-based finance and equity markets specialist).

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