Midcap and smallcap stocks are broadly trading at less than historical discounts to their bigger peers and offer low margin of safely on current profits. But the end of quantitative tightening and a likely better profit trajectory ahead may lend support to them going ahead, said ICICI Securities in its latest strategy note.
The valuation discount of midcap stocks over large caps in terms of earnings yield spread is low at around 10 basis points on a trailing 12-month basis and offers little ‘margin of safety’, the brokerage said. That said, midcaps have not yet reached the extreme optimism seen during 2017-18 where they traded at a premium to large caps, it noted.
Small and micro caps, on the other hand, have a relatively higher ‘margin of safety’, as valuation discount over large caps in terms of earnings yield spread stands at 90 bps and 260 bps, respectively. But here also, the discount is lower than the average of the past decade. "To be sure, small caps traded at a premium valuation to large caps just like midcaps during the peak optimism of 2018," it said.
Here are the reasons why ICICI Securities sees midcap and smallcap stocks going well going ahead.
1) Consensus earnings growth of Nifty small cap 100 and Nifty midcap 100 index over FY23E to FY25E may exceed Nifty50 earnings growth, which could support their valuations, the brokerage said. The higher higher growth expectations going ahead (FY23E to FY25E) for Nifty small cap 100 index (22 per cent compounded annually) and Nifty midcap 100 index (23 per cent CAGR – ex Vodafone) is attributable to the normalisation of profit within financials, industrials, discretionary consumption and commodities, it said.
2) ICICI Securities said FPI selling of small caps seen since 2018 has likely bottomed out. FPI holding in small caps has been on a downhill since the peak of 2018 when they held close to 17 per cent, but has formed a bottom of 12 per cent in June 2022. Since then, their holding has risen to 13 per cent in December quarter, ICICI Securities noted. Midcap stocks, on the other hand, haven’t seen any major erosion in FPI holdings since the peak of 2018 and oscillated in 14-16 per cent range.
3) ICICI Securities said the peak of aggressive rate hike cycle for US and likely pivot at some point going ahead will be positive for mid and small cap valuations. It said a key risk to mid and small cap stocks is a surge in the discount rate like the one observed in 2022 that resulted in their underperformance.
"However, 2023 has started off with the downshifting of the rate hikes by the US Fed as inflation starts to moderate. Rate hike cycle may halt in 2023, which is positive for the valuations of mid and small caps in general," it said.
Stocks to buy
Among stocks that are available at steep discounts to Nifty, ICICI Securities likes Oil India among midcaps and small caps such as South Indian Bank, Manappuram Finance, Jindal Stainless and Fusion Micro Finance.
ICICI prefers NHPC among midcaps that trade at high-moderate discount to Nifty50. Gujarat State Petronet (GSPL), Greenpanel Industries and Chemplast Sanmar are among smallcap stocks that it likes in the list.
Among stocks that trade at moderate discount to Nifty50 valuations, ICICI Securities likes Tata Communications, Indraprastha Gas among midcaps; and Mahindra CIE, Gokaldas Exports, VRL Logistics, Techno Electric and EPL among smallcaps.
Meanwhile, there are many midcap and smallcap stocks that ICICI Securities like, even as they trade at a premium to Nifty50 valuations. They included Gujarat Fluoro, TVS Motors, Dalmia Bharat, Phoenix Mills, Aavas Financer, Solar Industries, Indian Hotel, Jubilant FoodWorks, Motherson, Balkrishna, BHEL and Thermax among midcaps.
Genus Power, Just Dial, Jyothy Labs, GE T&D India, Century Ply, Lemon Tree, Orient Electric, Brigade Enterprises and Metro Brands are among smallcaps trading at premium to largecap valuations, but still look attractive, as per ICICI Securities.
(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of Business Today)
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