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Time to hunt for undervalued small and midcap stocks: Experts

Rashmi Pratap     September 27, 2019

Some of the best small and midcap stocks are currently deeply undervalued, making it the right time for retail investors to consider adding them in their portfolio.

While Sensex moved up 8 per cent in just two sessions after Finance Minister Nirmala Sitharaman on September 20 announced a cut in corporate tax rate, most of the gains were factored in large cap stocks as they stood to gain the most from the cuts.

"After reforms (reduction in corporate tax and withdrawal of enhanced surcharge on FPIs), good quality small and mid-caps are also improving. These stocks have suffered the maximum stress since January 2018 and now there is great opportunity for quality stocks in this space," says G Chokkalingam, Founder, Equinomics Research and Advisory.

The collective market capitalisation of BSE B group shares (small and mid-caps) was Rs 20 lakh crore in 2017-18 and it fell to Rs 8 lakh crore before the announcements by Sitharaman. "Ten years ago, the figure was Rs 8 lakh crore, showing that these stocks are under-valued," he added.

UR Bhat, Fund Manager, Dalton Capital Advisors says prices of small and mid-caps have fallen a lot from their peak. "They are not as well equipped as large caps to face any adversity in the economy. So they are quoting at a discount now," he said.

The BSE Midcap index is currently valued at 27x its underlying earnings in the trailing 12-months a sharp decline from price to earnings multiple of 35x a year ago. In comparison, the benchmark BSE Sensex is trading at 27.3x its trailing earnings. This is first time in over two years that the mid-cap index is trading at a discount to the benchmark indices that comprise large cap stocks.

There has been a sharp valuation de-rating in the smallcap index. The BSE Smallcap index is now trading at 41.9x its trailing earnings against its peak valuation of 60x.

This, the analysts say, makes smaller stocks more attractive compared to their valuation two-years ago but investors have to be selective as consumer demand and earnings growth are no more as robust and secular as a year-ago.

Chokkalingam suggests applying four filters while investing in mid and smallcap stocks - management quality should be good, the companies should have the least amount of leverage, no major pledging by promoters and the scrips should give valuation comfort. "If someone chooses quality stocks based on this filtering, it is great opportunity to buy in the space," he adds.

Investors had lost a lot of money in over-valued small and midcaps post January 2018. "Investors were forced to sell even quality stocks to make up for losses. They also lost the bargaining power to make quality purchases when prices crashed," says Chokkalingam.

However, from a valuation perspective and relative valuation when compared to historical levels, mid and smallcap stocks are more attractive than largecap stocks on the basis of indices.

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