Why are large-cap stocks looking attractive now?

Thinning valuation gap between these and mid-caps indicates a shift in investors' preferences, says Hamsini Karthik

Illustration: Uttam Ghosh/Rediff.com

After nearly three years of trading on the BSE at a significant discount to the benchmark Sensex, the asking rate for large-cap stocks is increasing once again. The S&P BSE Sensex currently trades at 17.3 times the estimated calendar year 2017 earnings, while the BSE Mid-cap index is at 18.7 times, by Bloomberg calculations.

The premium commanded by mid-caps vis-a-vis the Sensex has thereby reduced to 7.5 per cent.

Mid-caps had started trading at a premium to large-caps from 2014 onwards. The BSE Mid-cap index premium over the Sensex, 10.3 per cent in 2014, rose to 28.7 per cent in 2015 and was 21.3 per cent in 2016.

Experts say the changing trend is a positive one and in favour of large-cap stocks. "It is a combination of money chasing large-caps, led by Reliance Industries, and investors realising there aren't too many affordable pockets in the mid-cap space," explains Pramod Gubbi, head of equities at Ambit Capital.

He adds that in a typical bull market, there tends to be an earnings upgrade for mid-caps, resulting in a valuation premium expansion for these stocks. "In the current scenario, the premium is narrowing and this indicates that investors are running for safety."

A scenario such as this also highlights a reduction in risk appetite. A fund manager with a diversified portfolio has a similar opinion.

"It is becoming hard to choose among mid-caps. I prefer to park funds in asset classes which are more liquid like the large-caps than the relatively less liquid mid-caps and small-caps," he says.

There's more on why investors need caution in dealing with mid-caps.

In a report this week, analysts led by Sanjeev Prasad of Kotak Institutional Equities, said: "We find valuations of several mid-cap stocks in our coverage universe very high. In fact, it would not be wrong to say that some are in a 'bubble' phase, with the market extrapolating strong growth and high returns in perpetuity."

While some of the companies do have certain strengths, they add, the valuations at over five times the book for several semi-branded (semi-commodity) businesses are absurdly high in the context of their business models and limited competitive advantages.

While experts advise caution, they believe despite these challenges, investors should not ignore the mid-cap space.

One reason is the flush of liquidity, particularly with domestic investors. That domestic institutional investors (DIIs) have been the saviours for Indian equities is an established point.

For most of 2016, when foreign portfolio investors (FPIs) were sellers in Indian stocks, DII buying lent strong support to the market. The trend remains.

In April, FIIs have sold equities worth Rs 712 crore so far; DIIs have mopped Rs 1,077 crore of shares.

Experts say DIIs have more ammunition and seem likely to remain as critical pillars of liquidity for Indian equities. But, more important, there is long-term growth potential in quite a few mid-caps and this could help them emerge as larger companies over the coming years.

And, if investors could spot such companies and buy the stock during steep price corrections, it could yield good long-term returns.

Pankay Pandey, head of research at ICICI Securities, feels mid-cap stocks which promise earnings growth might continue to trade at a premium to their large-cap peers.

"The past four years have been disruptive with respect to earnings growth. The commodities cycle, a poor monsoon and now demonetisation have all been reasons for earnings growth to be pushed," he says.

In such conditions, he believes any stock offering a promise of earnings growth will continue to get a fair share of investor interest.

Experts say any market correction could be used to accumulate promising mid-cap stocks such as Mahanagar Gas, Indraprastha Gas, Marico, Dabur, Emami, NCC and ITD Cementation.

In large-caps, Tata Motors, GAIL, Power Grid, HCL Technologies and State Bank of India continue to offer value.