More steam left in mid, smallcap; high valuations seem distorted by loss pools

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So don’t throw in the towel on midcaps and smallcaps yet, they said in a research note.

For FY21, the Smallcap100 index's loss pool contribution stood at 53 percent to the aggregate profit base of Rs 7,600 crore, while in the midcap space the loss pool contribution is was 42 pecent to the aggregate profit base of Rs 32,300 crore.

On the flip side, for the Nifty50 index, the contribution to the loss pool was around 2 percent for FY21.

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"Negative earnings are meaningless for analysing P/E or earnings yield ratio of a stock. Introducing such companies into aggregate index level calculations can completely distort the picture especially if the loss pools are significant as seen in the case of mid and smallcap indices mentioned above," they added.

This means, the smallcaps and midcaps look expensive, but it is the loss-making companies or high loss pool that is inflating their P/E levels.

"Hence, managing risk becomes paramount while investing in the broader market, and investors should steer clear of speculative stories which are not supported by adequate earnings yield, growth prospects and quality of business," Karki and Gupta said.

Meanwhile, the earnings growth expected to be robust in mid and smallcap space over FY21-23.

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"We believe 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 NIFTY50’s growth. Improving growth can support valuations in the broader market thereby, providing moderate returns (10-15 percent), given the reduced valuation gap with large caps. On the flip side, expectations of a sharp outperformance from mid and small caps going ahead will be belied," they added.

Among the midcap and smallcap segments from ICICI Securities' coverage universe, Karki and Gupta have shortlisted 21 stocks with a fundamental ‘buy’ rating and high levels of earnings yield spread over largecaps.