Updated view on midcaps – January 21, 2022

7th note in the series. Performance has been exactly in line with the last update in July 2021. What next?

In my last note on July 15, 2021, I had turned ‘Neutral’ on the Indian Midcaps vis-a-vis the Largecaps. Consensus at that time was Positive.

Checkout the actual performance –

Midcaps grossly under performed initially but then caught up with the Largecaps and have been moving in tandem thereafter. It’s also worth reminding here that consensus view at that time was positive.

Infact, midcaps performing in line with the view in the notes has been the track record so far. Checkout the following table –

(Links to all the previous notes are provided at the end for easy reference)

So what now… any change to the ‘Neutral’ view of last time?

Before trying to answer this, let’s relook at the reasons for the Neutral view previously –

  • Abundant global liquidity, but aggressive deployment constrained by caution gradually creeping into the mind of the large investors;
  • Continued strength in the economy, but margins getting hit due to inflation and potential tightening of the interest rates;
  • Midcap valuations getting much closer to the largecaps warranting cool-off;
  • Technically overbought position in midcaps; and
  • Overall sentiments wherein too much of positives were built in and hence some realignment.

I am sure, most of you would agree, majority of these factors played out in ensuring a neutral performance by the Midcaps.

Tightening of interest rates didn’t happen and personally I would attribute Omicron for that getting pushed further down. Policy makers globally just don’t have the courage to act in an uncertain environment.

In hindsight, if that had happened, maybe midcaps would have under performed taking my neutral stance to the cleaners !

Coming back to the view now. Let’s look at the key factors I am considering –

1. Global Liquidity

The best seems to be behind us.

  • Covid related uncertainty is nearing an end. Though the pandemic may continue to linger for some more time, I am expecting it to continue to wane taking away one of the key reasons for the accommodative policies.
  • Inflation continues to remain elevated. Yields are making an effort towards hardening. Regulators would not be able to ignore this for long and tightening is only a matter of time. Under the scenario, I don’t expect many large investors to play aggressive now – especially after making so much profits over the last couple of years.
  • Fund flows over the last few months, where phases of selling is outweighing buying are also pointing towards the current phase being distribution as against accumulation.

Under the scenario, I don’t expect a liquidity pushed sustainable rally anymore. Whether it would mean a sustained broad sell off – that is unlikely too.

2. Indian Economy and Corporate Results

I continue to remain constructive on both Indian economy and the expected corporate results.

  • Indian economy has got structural tailwinds especially due to the revival in core sectors including real estate, auto and commodities. I believe this bodes well for at least medium term.
  • However, given that some of these sectors have performed exceedingly well in the last 1-2 years, would mean high expectations are built into the current stock prices – especially commodities and real estate. These may get normalised in the short term.
  • I am expecting discretionary demand to somewhat cool off in the short term both due to inflation as well as pent-up demand/ revenge buying getting over for many products. However, sectors like aviation and hospitality might be exceptions, and could benefit significantly as Covid starts waning. Even for other sectors, I am only expecting normalisation of demand and nothing significantly negative – especially given that the income levels have broadly increased.
  • Corporate margins that had got hit due to inflation should get normalised over the next 2-3 quarters, mainly due to price increases.

Under the scenario, I would continue to avoid over expectations and look for opportunities in the under expectations.

3. Valuations

Like last time, Midcaps continue to trade similar to Largecap multiples at > 20x P/E providing no real arbitrage.

On this parameter alone, midcaps should perform negative to neutral relative to the largecaps.

4. Technical charts

Midcaps look significantly over stretched vis-a-vis largecaps over long period. Over medium term, it looks a much comparable performance. However, over shorter period (since Covid led fall) they have outperformed significantly and are recently moving in tandem.

One would expect this to normalise, again indicating a negative to neutral technical outlook going forward.

5. Some other observations worth considering

As always, I try to combine the above with some of my other general observations to arrive at the final outlook. People connected with me on twitter would surely relate.

See, if they make sense to you.

  • Retail in general continues to be bullish about the overall markets. Continued heavy fund flows to the mutual funds and general discussions on social media, whatsapp groups, private discussions support this. There is a continued interest in buying stories without caring about the underlying fundamentals and the valuation multiples. Reality check under such conditions is bound to happen sooner than later.
  • There is an increasing tendency to punish stocks significantly for under performance vs expectations. This is especially happening in over stretched stocks with built-in high expectations. To me, it means that large investors have started looking at valuations more closely.
  • Contrary to the last time, many stocks are forming double/ multiple tops and finding it difficult to cross previous highs, giving indications of topping out.
  • Parallely, however there are many stocks that continue to increase significantly. Some of these are operator driven and others are factoring in turnarounds with policy support and/ or sectoral tailwinds.
  • Upcoming budget, with improving economy and hence government finances, should ideally create a favorable outlook – atleast for the short term.

Considering all the above, I am changing the outlook from Neutral to “Cautious” on the midcaps.

Main reason – changing underlying sentiments.

  • Abundant liquidity is changing into cautious liquidity
  • Normalisation of demand, margins and hence expectations – implying a closer look at the valuations

I believe this is not going to be a year of easy money. I don’t expect a sustained deep sell off but I expect more of a realignment.

In the process, people are bound to look at largecaps more closely vis-a-vis midcaps.

Proven track record, better corporate governance standards and relative under valuation of the largecaps should ideally work in their favor in the current environment.

Disclaimer: Above are my personal opinions and not any recommendation. The reader should do his own research before making any investment.

Previous notes on the subject –

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2 years ago

Makes sense

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