Midcap or Madcaps! More than 50 stocks trading above 5-year Avg P/E; still a buy?

Midcap stocks have not gone out of flavor since PM Modi-led government came to power back in May 2014. The S&P BSE Midcap index nearly doubled since then and gave over 30 percent return in the financial year 2017.

The S&P BSE Midcap index hit a fresh record high of 14,266.94 while the S&P BSE Sensex had a touch and go moment with mount 30K.

The euphoria seen in the midcap space has indeed pushed up valuations of many midcap stocks above their historic averages; hence, stock selection has become tough if somebody wants to invest money right now.

On a trailing basis, currently, the S&P BSE midcap index is trading at 31x PE (trailing) and Sensex is trading at 22x PE, which is higher compared to the historical average. But, the rally in midcap stocks despite their lofty valuations may not be over, suggest experts.

If we apply a simple valuation parameter — 5-year average P/E. We found out that in the S&P BSE midcap index nearly 20 stocks are trading below their average P/E multiple of last five years while more than 50 stocks are trading above their 5-year average P/E multiple.

Let’s first understand what is a P/E ratio? A price to earnings ratio (P/E) is computed by dividing the market price with the company's earnings per share (EPS).

When this ratio is compared with historic trend such as 5-year average P/E it gives useful information to investors on the stock if it is undervalued or overvalued.

Stocks trading above historic averages?

In the S&P BSE midcap index more than 50 companies are trading above their historic averages which include names like Bajaj Finserv, L&T Finance Holdings, GMR Infrastructure, MAX Financials, Blue Dart, Crisil, Emami, UPL, Page Industries, Blue Dart, Apollo Hospitals, Marico, Kansai Nerolac, Havells India, Biocon etc. among others.

The Indian market was flooded with domestic and global liquidity and most of the funds coming from mutual funds usually get diverted towards midcap stocks because most of the foreign institutional investors prefer to buy largecap stocks.

In the rising bull market, like the one we are in now, stocks which are performing will continue to outperform and stocks which are trading below their historic averages should be considered but with a pinch of salt.

“A 5 year is considered as a good long term period to capture at least 2 market cycles, hence it is often considered to measure long-term performance as well,” Siddhartha Khemka, Head – Equity Research (Wealth), Centrum Broking told moneycontrol.

“With broader market reaching near all-time high levels, stocks which are currently doing well or are expected to do well are also trading near their highs,” he said.

Stocks trading below historic averages?

At a time when most of the midcap stocks are trading at record highs, there are stocks which are trading below their historical averages. Does that make them a good buy?

In the S&P BSE midcap index, nearly 20 stocks are trading below the 5-years average historic average, which include names like 3M India, ABB, Divi’s Laboratories, Crompton Greaves, MRPL, Tata Communications, Tata Global Beverages, Wockhardt, Castrol India, Ashok Leyland, Adani Enterprises, Glenmark Pharma etc. among others.

Investors should understand that just because a stock is trading below their historic average, does not become attractive automatically. If we look at the list of stocks we would found out that most of the stocks are going through either company specific problem or slowdown in demand in that particular industry.

We are in a bull market and the saying goes that rising tide take everything higher and if some stocks are still trading below their historic averages then investors should not assume that they are good buys at current levels.

“Prima facie investors have to take such stocks with a pinch of salt, especially when the market is in the middle of bulls grip. Generally speaking, when the market picks up, good quality shares are scooped up first and therefore their valuations become lofty in the early stages,” Jimeet Modi, CEO, SAMCO Securities told moneycontrol.

“Majority of stocks should be avoided which are trading below their historic average unless a sectoral weakness has battered the entire sector for one reason or the other. For instance, currently Pharma and IT. Eventually, such sector will turn around,” he said.

Modi further added that a stock specific selection or a bottom-up approach should be avoided for stocks that are available at below their 5 years valuation parameters.