Sensex firms beat mid-caps in earnings

The mid-cap rally on Dalal Street seems to be treading on thin ice. The BSE Midcap index is up 169 per cent since September 2013, when the current rally began, outperforming the benchmark BSE Sensex by a factor of nearly three, but it is not supported by the underlying fundamentals.

Contrary to popular perception, midcap companies reported slow earnings growth compared with the Sensex companies during the period.

The underlying earnings per share (EPS) of the 30 Sensex companies is up 20 per cent during the period, outpacing mid-caps, which have reported cumulative EPS growth of five per cent.

The Sensex companies’ underlying EPS has grown at a compound annual rate of 5.3 per cent since September 2013, against 1.3 per cent for mid-caps.

As a result, the mid-cap index price to earnings (P/E) multiple is up 157 per cent since the end of August 2013 while the Sensex has become dearer by only 36 per cent during the period.

The analysis is based on the monthend index values (Sensex and BSE Midcap index) and their trailing 12months P/E multiple, dividend yield and price to book value ratio.

Even on a longer term, mid-caps have not done better than large-cap companies in earnings growth. The Sensex companies’ underlying EPS grew at a CAGR of 9.7 per cent since September 2005, better than the nine per cent annualised growth in the EPS of the BSE Midcap index during the period. The valuation ratios of the BSE Midcap index are available since September 2005.

Dhananjay Sinha, head of research, Emkay Global, said it was the experts who sold the mid-cap story to retail investors in the run-up to the 2014 general elections and immediately after that where there was exuberance about the likelihood of faster earnings growth under the new government. “The midcap rally has been good for the mutual fund industry and flows have been positive in the last three years after being negative for many years since the Lehman crisis,” he added.

“Earlier the rally was always thematic, but now investors are willing to buy any small stock as long as the growth story sounds promising. This has created a valuation bubble in mid and small caps,” said G Chokkalingam, founder and chief executive officer, Equinomics Research & Advisory.

A typical mid-cap company also has weak financial ratios compared to its large-cap peer. For example, the midcap index companies have an average return on equity (RoE) of 8.7 per cent, nearly a third lower than Sensex companies’ average RoE of 13.1 per cent currently. At this rate, a typical mid-cap company earns a lower return on shareholders’ equity than the cost of its borrowings.

Mid-caps, however, score over Sensex companies when it comes to rewarding shareholders with dividends. In the last three-and-a-half years, dividend payout (the proportion of annual net profit distributed as equity dividend) by mid-cap companies has grown at a CAGR of 20.4 per cent, nearly three times faster than the 6 per cent growth in the dividend payout by Sensex companies.

But numbers suggest that mid-caps paid a higher proportion of their profits as dividend since 2013. Mid-cap companies now give away 38 per cent of their net profit as equity dividend, up from 21.5 per cent at the end of August 2013. In comparison, the Sensex companies’ payout ratio has remained unchanged at around 28 per cent over the period with a minor jump in 2015.