The strong outperformance of the mid cap index is raising questions on valuations and froth in the markets. Will this rally continue? The answer is that the mid cap rally will continue despite high valuations as investors chase growth. In the current market environment, all the gains are being taken up by private investors who are investing in the unlisted space. Money is flowing out of the broad market into the private space and that is leaving the large cap stocks underperforming the market.
Mid cap stocks are offering growth, which is not prevalent in large cap stocks and that is leading the rally. Liquidity will continue to chase returns and given that the average retail investor is left out of the private space, the choice becomes limited.
The mid-cap index is rallying ahead of the benchmark BSE Sensex. The BSE Mid-cap index has outperformed the BSE benchmark Sensex by 26.6% since April last year, in its biggest and longest period of outperformance. The index has gained 58% since April 2014, compared with the 25% gain for the Sensex and 27% for the Nifty during the period. In a one year time period the BSE Midcap index has gained 34% compared with 9% gain for BSE Sensex. The Price to Earnings ratio for the BSE Midcap index is 26 as compared to a ratio of 22 for the BSE Sensex.
Finance, Healthcare, Transport Equipment and FMCG have a weightage of 29.2%, 13.56%, 12.53% and 11.86% respectively in the S&P BSE Midcap Index. The other sectors such as Oil and Gas, Capital Goods, Information Technology have less than 5% weight in the index.
The top 5 performers in a one year time period are Welspun India (Textiles Sector), Rajesh Exports (Diamond and Jewellery Sector), Hitachi Home and Life Solutions (Consumer Durables), PC Jewellers and Bombay Burmah Trading Corporation with a gain of 288%, 276%, 260%, 215% and 195% respectively in their stock prices.
Finance has the highest weightage in the index but the top performers are from different sectors altogether. In the Healthcare sector companies such as Ajanta Pharma have gained 177.68% followed by Sun Pharma Advanced Research Company (148%) and Natco Pharma (140%) which appear in the top ten performers in a one year time period. Top Gainer in the Transport Equipment sector is WABCO India with a gain of 100% followed by Asahi Glass India with 94% gain in one year. Relaxo Footwear has gained 186% and Gillete India in the FMCG space has gained 130% in the same time period. Zensar Technologies is the top gainer in the IT space with a 100% return.
The stellar performance of the stocks has come on account of either growth in revenues and profitability or either of the two. For example Rajesh Exports Ltd. had reported over three-fold jump in net profit to Rs.2055 million for the quarter ended March 31 2015, on the back of healthy performance in exports, wholesale and retail businesses.
Rise in the earnings per share have driven valuations to expensive levels. The expectation of continued performance is also high for these stocks and they continue to trade at higher valuations in comparison to other stocks in the midcap space. For example Rajesh Exports Ltd. trades at a Price to Earnings ratio of 53. Although the rise in the earnings keeps on discounting the PE ratio of the stock at a rapid pace, valuations seem to be higher due to higher expectations of growth in the near future.
The rally in mid-caps is attributed to strong flows from domestic retail investors and mutual funds. The shareholding pattern of the BSE 500 companies shows a relative withdrawal by foreign investors and the gap being filled by domestic investors. FIIs’ ownership of the BSE 500 companies declined to 23.9 % at the end of June this year, from a record high of 26.3 % at the end of March 2015. During the three-month period, public (non-institutional) holding increased to 10.3 % from 8.6 %, while domestic institutions (insurance plus mutual funds) raised their effective ownership to 11.3 % from 10.3 % at the end of 2014-15.