Earnings will test mid-, small-cap rally

Mid-cap and small-cap stocks tend to perform well during periods of economic revival. But, in late 2021, the discovery of the Omicron variant has raised concerns over economic growth again. Nevertheless, Dalal Street participants are bullish on listed mid- and small-cap stocks and this optimism is well captured in FY13 earnings growth expectations. BofA Securities in a note to clients said, “Street produced strong earnings growth (+44% / +34%) for mid-/small-cap versus large-cap (+18%) for FY23 Is.”

These projections appear to be aggressive against the backdrop of economic activity losing steam. In addition, companies across the board have been grappling with severe operating cost pressures over the past few quarters. Broadly speaking, as many companies have hiked prices, the impact of stable input cost inflation on mid-cap and small-cap firms is yet to be seen. Note that demand has not yet reached pre-pandemic levels in many regions. Accordingly, analysts caution that smaller companies will report higher margin compression in Q3 22 than larger counterparts.

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Analysts at Jefferies India Pvt Ltd commenting on the mid-caps in their coverage. Ltd. said in a report on January 10, “Post a stellar H1FY22 (Profit after sales/tax on weak basis +34%/+63% y-o-y), we expect higher year-on-year basis (pent-up demand) and margin pressures.” We expect (raw material inflation) to moderate growth in Q3FY22.”

It is true that the recent moderation in commodity prices has provided relief. But its impact on earnings will be visible in a span of a few quarters. However, until this happens, there is a risk of declining earnings on these stocks.

“We see a risk of declining consensus earnings for consumer discretionary on the higher price inflation seen last year and slowing consumption volume growth on materials sectors as we expect a 19% cut in steel prices in FY23. These sectors account for 30% of the mid-cap index and are likely to put pressure on earnings,” said Amish Shah, managing director and head of India research at BofA Securities India Ltd.

He is not everything. Expected monetary policy tightening and withdrawal of stimulus is a general downside for equities. Due to these factors, in the event of a correction, the prices of mid-cap and small-cap stocks may see a sharp decline. This is simply because in a bull market mid-caps tend to rally faster than blue chips; However, they become equally difficult when the market goes down.

Evaluation is another problem. Bloomberg data shows that taking into account the consensus earnings growth projections for FY13, Nifty 50, Nifty Midcap 100 and Nifty Smallcap 100 have price-to-earnings multiples of 20.68x, 21.38x and 19.48x, respectively. doing business on. Mid- and small-sized companies are trading at higher valuations despite relatively weaker fundamentals and higher exposure to downside risks. “Large-cap stocks are now trading at a discount to mid-cap stocks and are almost at par with small-cap stocks, which are generally traded among large-cap stocks,” Shah said. BofA prefers large-caps with contracted valuation premiums to the sensitivity of mid-cap and small-cap stocks to near-term headwinds.

“The biggest potential risk for investors is a slowdown in growth. If earnings growth falters, it could lead to massive de-rating of valuation multiples of mid- and small-cap stocks,” said Aishwarya Dadhich, fund manager, Ambit Asset Management said.

Meanwhile, in the third quarter, investors in these stocks should heed management’s comments on demand trends, price increases, new launches and cost rationalization measures.