Published on 11/03/2019 1:20:03 PM | Source: ICICI Securities Ltd

Risk tolerance for mid- & small-caps have not hit the bottom By ICICI Securities

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Risk tolerance for mid- & small-caps have not hit the bottom

Testing the hypothesis of reversal in mid- & small-cap stocks:

Our analysis, shows that the low risk tolerance behaviour within equities has not hit the bottom as past instances of high risk aversion have resulted in the trailing earnings yield spread between small- and large-cap stocks widening much more than suggested by current prices. Also, expensive large caps are overstating the yield spread for mid- and smallcaps. Absence of fundamental catalysts such as up cycle earnings and broad based pick up in private investments is a key headwind for mid- and small-cap stocks. However, the silver lining is that India Inc’s profit pool with earnings yield higher than bond yield has jumped by 106% since Jan’18, thereby providing selective buying opportunities. Our mid- and small-cap strategy from a value perspective would be to progressively buy market leaders within their sectors with high RoEs > 15% ; earnings yield higher than the mid cap average of 5% and earnings growth expectation > nominal GDP growth. Best picks: Balkrishna Ind, Galaxy Surfactants, Mahanagar Gas, Jagran Prakashan, Jubilant Life Sciences and Parag Milk Foods.


* Risk tolerance hit its peak during Jan’18; has started normalising:

Due to high risk tolerance, the expected linear correlation between rising earnings yield (return indicator) with decreasing market cap (risk indicator) broke down in Jan’18. Earnings yield starting at 4.2% for the large caps remained largely flat with decreasing market cap (In fact mid cap earnings yield dipped below large caps which was last observed during FY06). Since then, the sharp correction in mid- and small-cap stocks has resulted in the normalising of the risk- reward continuum as spreads widened (earnings yield of stocks; Large: 4.6%, Mid: 5.1% and small: 6.6%).

* However risk spread continues to be below long term average:

Despite the sharp correction, the earnings yield spread of mid- and small-caps over large caps is still below their 10 year average of 0.9% and 2.7%% respectively.(most recent flare up in spreads for mid- and small-cap was in Feb’14 at 2.2% and 4.8% respectively). Spreads of mid- and small-cap stocks have been suppressed since FY14 and any comparision with this period does not reflect the long term range.

* Error in relative valuations as current risk spread overstated due to expensive large-caps:

Large-caps have been considerably immune to the sharp correction in the broader market and are currently having a trailing earnings yield of 4.6%, this is much lower than earlier instances of risk-aversion thereby creating an illusion of improving relative valuations for mid- and small-caps. Large-cap earnings yield during earlier instances of risk aversion in Feb’14, Jan’09 and Jul’ 06 was much higher at 7%, 9.5% and 5.9% respectively.

* Yield spread of mid- and small-cap over bond yield below average:

With government bond yield at 7.4%, the earnings yield spread of -2.3% and -0.7% for the mid- and small-caps is below their 10 year average of -1% and +0.6% respectively.

* Silver lining: Profit pool yielding higher than bond yield jumps by 106% : Since Jan’18, amongst the top 1000 market cap universe, the aggregate profit pool of large-caps that had an earnings yield more than bond yield has shot up by 81% from Rs858bn to Rs1.55tn. The jump is even starker for the mid-caps and smallcaps at 126% and 251% respectively. Bulk of the jump in profit pool with earnings yield > bond yield is from metals, utilities, industrials, NBFCs, auto and private banks. Our preferred strategy would be to find mid- or small-caps that dominate their respective sectors and have seen significant correction since Jan’18.

* Size and risk - inversely related:

Basic assumption is that smaller the size of a business compared to its larger peers, higher the risk in terms of uncertainty of expected outcomes. This argument is also corroborated with the trend of falling RoE as market cap falls (median RoE of D1 by market cap is 21% while D10 is 12% with declining trend from D1 to D10). 


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