Experts warn of bubble in some mid-cap stocks

Participants have accepted super-high valuation as norm

While equity markets are trading near their alltime high despite stretched valuations, analysts at Kotak Institutional Equities said the market participants have largely accepted the high valuations of growth stocks as normal valuations without questioning the sustainability of the factors that supported it.

They noted that the overall market valuations look palatable, but hide the super rich valuations of growth stocks and expensive valuations of companies with mediocre business models.

On the mid-cap segment, they warned that a lot of companies are in the bubble phase with the market extrapolating strong growth and high returns in perpetuity.

“While some of the companies do have certain strengths, we find valuations at over fivetimes book for several semi-branded (semi-commodity) businesses absurdly high in the context of their business models and limited competitive advantages,” said Sanjeev Prasad, Sunita Baldawa and Anindya Bhowmik of Kotak Institutional Equities in their latest report.

The very high earnings multiples enjoyed by stocks in several semicommodity sectors like automobiles, cement, consumer products and industrials with moderate-to-high return on equities (RoEs) suggest that the market expects these sectors to deliver high volume growth for a long time and sustain high RoEs in the future. This also shows that the markets are not expecting competition to gather pace for an extended period of time.

However, analysts at Kotak believes that the government’s focus on ease of doing business will create favourable conditions for more competition in the Indian economy with easy entry and exit of players in segments that enjoy high financial returns. The greater competition is likely to dent the high financial returns of incumbents in many businesses.

“We do not find great sustainable competitive advantages (brand, tech) in the business models of firms producing semibranded or semi-commodity products. Most of them have a low focus on branding and technology. Several outsource their manufacturing to smaller Indian companies or assemble imported components. They do enjoy distribution strengths given their large distribution reach, but online distribution can easily disrupt this advantage,” Kotak Institutional Equities said.