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Why institutions are finding greater comfort in midcaps

In the ongoing equity market rally, institutional investors have increasingly been focusing on putting money in mid-cap stocks rather than their large-cap peers.

Over the past one year, the BSE Midcap index has outpaced the large-cap focused Sensex by a wide margin (a 58 percent rise compared to 33 percent for the Sensex). The story is similar over the past six-month performance.

In an interview with CNBC-TV18’s Latha Venkatesh and Ekta Batra, Rahul Arora, CEO of Nirmal Bang Institutional Equities, attributed the midcap rally to better valuations for such stocks.

“Valuations seem to have sort of breached fair value and in some cases even gotten ahead of themselves in large-caps,” Arora said, adding that valuation comfort still existed in case of midcaps.

For instance, the BSE Midcap index is still trading below its all-time highs of above 10,000 that it scaled in early 2008 while the Sensex has well breached past 2008 highs. Even on a historical PE basis, the midcap index is trading at 13.5 times earnings compared to about 19 times for the Sensex – with the valuation premium being higher than the historical average.

“On an aggregate basis, midcaps’ results have been better than large-caps in most sectors. So I am not surprised to see the interest there and it would not be imprudent to say that incrementally from here as well, that’s where some of the quicker money can be made,” he added.

Below is the transcript of the interview on CNBC-TV18.

Latha: It is a runaway rally in the midcap space over the past few days. Will this be the tenure for the next for the remaining quarter of 2014: we will see midcaps catching up?

A: The answer to that is a lot of our clients that we speak to don’t expect an incremental upside on the markets in the immediate short-term – on the domestic institutional side, at least. So the last two or three days where you have got these extra 200-250 points on account of the Bank of Japan (BOJ) liquidity infusion, the action by large will be concentrated in midcaps. That’s because the leadership questions are there and valuations seem to have sort of breached fair value and in some cases even gotten ahead of themselves in large-caps.

Your point is very valid that the interest is there in the midcaps. There is still some amount of valuation comfort over there and that’s why you are seeing the midcap index also above 12,000 today. If you look across the board, on an aggregate basis, midcaps’ results have been better than large-caps in most sectors. So I am not surprised to see the interest there and it would not be imprudent to say that incrementally from here as well, that’s where some of the quicker money can be made.

Ekta: Bata is a stock that you have been speaking about earlier and the results come out today. Your expectations on the numbers and even in terms of valuations any target prices you can share with us?

A: We remain positive on Bata . We are expecting over a 10-12 percent growth on sales, EBITDA and profits today. The stock goes at about 27-28 times one year forward. It is a multi-national company (MNC) that’s likely to generate about Rs 700-800 crore of free cashflow over the next two-three years, where you’ve seen the parent intend to buy in to the stock — you had the parent buy in to the company by 1 percent last year — and it is the largest organised footwear company in India and it doesn’t even do half a billion dollars worth of sales. So if you want to talk about spending kicking up, even maybe not in the immediate future but with a lag of a year or two or three years, this could be a very good stock to play.

Our immediate price target would probably suggest something like a 20-25 percent upside from a one-year perspective. However if you are ready to play the story from a slightly longer-term perspective the returns could be manifold in this stock.

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