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Mid and smallcap stocks are on every investor’s radar as the Nifty MidCap 100 index surged 83% from 14,735 on June 29, 2020, to 27,036 on June 28, 2021. Likewise, even the Nifty SmallCap 100 index skyrocketed 109% during the same period compared to a rally of 53% in the benchmark index Nifty 50.

According to a report by ICICI Securities, largecaps have a trailing earnings yield of 3.5% while mid, small and micro caps continue to yield higher at 4.2%, 4.5% and 6%, respectively.

“While the yield spread of mid and smallcaps over largecaps has dipped sharply since the end of CY19 (the calendar year 2019) due to their outperformance, it has not disappeared or turned negative, which typically coincides with the peaking out of mid and smallcaps,” ICICI Securities said in a report.

Profit to GDP

The ‘Profit to GDP’ ratio, which has hit a 7-year high of 3% in FY21, driven by largecaps at 2.6% while mid and ‘small plus micro’ caps contribution is significantly compressed at 0.4% and 0% respectively. ICICI Securities believes as the economic recovery gains traction over the next couple of years, broader market earnings growth over the latter part of FY21-23 will be robust and are expected to be higher than Nifty 50’s growth. Improving growth can support valuations in the broader market thereby, providing moderate returns (10-15%), given the reduced valuation gap with large caps.

“Traditional headline price to earnings valuations of mid and smallcap indices are significantly distorted as they currently have significant loss pools thereby optically blowing up the numbers. On the other hand, largecap index (Nifty 50) loss pools have reduced significantly thereby, further distorting the relative valuation picture,” noted the report.

“Given the significant loss pools in the small and midcap indices, earnings growth expectations over FY21 -23 are steep and not comparable to the NIFTY50 growth,” the report stated.

The broader markets, especially in the smallcap space ‘margin of safety’ in terms of valuation discount had improved considerably by the end of CY19 and remained so as of September 2020.

“Since then, small and midcaps have significantly outperformed the Nifty 50 despite the economy going through a technical recession thereby, fuelling fears with regards to their valuation discount to largecaps,” added the report.

Top picks

Among the midcap space, ICICI Securities is bullish on ACC, Tata Communications, Power Finance Corporation, TVS Motors, Aditya Birla Capital, NHPC, Oil India and Federal Bank.

In the smallcap counters, the brokerage firm is gung-ho on Shriram City Union Finance, CESC, Mahindra CIE, Kalpataru Power, Engineers India, Bajaj Consumer, Karur Vysya Bank, Mishra Dhatu Nigam, PTC India, Green Panel Industries, Garden Reach Shipbuilders, VRL Logistics, Repco Home Finance and Visaka Industries.

(Disclaimer: The recommendations in this story are by the respective research and brokerage firm. Money9 & its management do not bear any responsibility for their investment advice. Please consult your investment advisor before investing)