Mid-Cap stocks

It looks like valuations are finally hitting a wall of worry…

As leading Indian brokers take a negative view on mid-caps, the question is whether the rally is actually over. There may be no simple answers. However, there are early indications that the mid-cap valuations are climbing a wall of worry. Here are 4 reasons why mid-cap valuations in India may be up against a major hurdle…

Valuation gap too high…

 The gap between the valuations of mid-caps versus large caps as well as mid-caps versus small caps is at all time high. While there have been strong reasons for sustaining such premium valuations, the rally has apparently gone on for too long. The recent spate of downgrades on mid-cap stocks is a first sign that the mid-caps may up against a wall of worry. Mid-caps are quoting at valuations of 30-50, which will be hard to justify based on earnings growth.

Business risks are understated…

 One of the major worries pertaining to mid-caps is that business risks tend to be understated, at least, when it comes to valuations. Mid caps have a concentration of business lines as well as limited clients. Any disruption in this chain can seriously impair the company’s performance. One can imagine the impact on auto ancillary companies when Volkswagen pleaded guilty to rigging pollution tests. Smaller software companies are overly dependent on a handful of BFSI companies to keep their order books flowing. Tighter regulatory oversight may seriously impair the performance of mid-cap MFIs and NBFCs which have been sharp outperformers in the last few months.

Commodity dividends are done…

One of the big benefits that mid-caps derived was from low price of oil and other commodities. In most cases these mid-cap companies were direct beneficiaries. With oil and commodity prices bottoming out, key input costs are likely to either stay flat or move up gradually. This will take a lot of sheen away from mid-cap stocks.

Disruption could be the big risk…

Mid cap companies have been on the forefront of innovation in most sectors. Having said that, these mid cap companies have also been the biggest losers in any industry disruption. For example in the software industry, small IT companies have been the big losers in the shift towards digital. Larger players have the staying power and the deep pockets to adapt to disruption. Most mid-cap companies in India do not. Similarly, as the RBI has gotten tough on bad assets in banking, it is the mid and the small banks that have been worst hit by the AQR. At some point, these 4 issues will have to reflect in mid cap fundamentals and valuations. ©

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