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.
Latha: Jubilant Foodworks is another of your picks: same store sales have been under pressure but to be fair they have some excellent new store plans?
A: It is a great story. From a three year prospective, this stock could give you anywhere between 70-100 percent kinds of returns. This company over the last 10 years has never had to raise equity or debt for a growing business. Even their initial public offering (IPO) was not an IPO because the company needed funds, it was an offer for sale for an existing investor to leave. It is opening about 150 stores each year, so there new stores incremental as a percentage of their existing stores is going to come down.
We actually expect that the earnings per share (EPS) of this company could triple over the next three years. From about Rs 17-18 in the current year it could probably head to about Rs 50-51 over three years. If you start discounting that backwards and I do not think that’s a stretch -- because for people who want to buy value stocks the least horizon that you need to have is a 2-3 years -- this is a company that is going to give you about Rs 500-700 crore for the operating cashflow and that’s not unsubstantial for a company that doesn’t have too many payouts beyond the operating cashflow.
The Dunkin Donuts model is doing really well for itself. The return on equity, which are currently at about 19 percent, we are expecting it to scale up to about 30 odd percent. We understand from the company that after they start generating free cashflow by Rs 16-17, they could even start at looking at a dividend payout. So whichever way you look at it, this will be a great way to play the urban recovery store.
On your specific point of same store growth you had four to five quarters on negative same store growth. If you are going to take a call that discretionary is going to pick up and we have reason to believe if you see the results of IFB Industries, Whirlpool and Hitachi there is reason to believe that discretionary will pick up. It may not happen in next six months to eight months but you buy a good business when times are tough, you don’t buy a good business when things start running up. So this could be the base effect on same store growth would also kick in. So this could be a one stock we you are looking at it from longer-term perspective definitely good money to be made.
Ekta: I am going to ask you about V-Guard because that stock just completely perplexes in terms of the strong run-up we have seen close to Rs 2,000 at this point in time and it is still a discount of around 20-25 percent to Havells which is its peer. Do you think that there is further upside because it is trading at around 16-17 times one year forward?
A: I believe that the valuations could breach the gap over the next two to three years with Havells. If you look at Havells, the Sylvania story is playing out pretty well in fact coincidentally I happened to meet the management of Havells last week as well. Sylvania is panning out pretty well for them. On Havells they are likely to generate about Rs 1,800 crore worth of free cashflows over the next two to three years and you see the return on invested capital going up by about 11-12 percent so that’s a huge number.
On V-Guard Industries the return on equity is going to be far more because the cash generation is not going to be as much. So it will probably be about a 600 basis point improvement on return on equity. The results were very strong.
If you look at KEC International, Thermax or even a V-Guard at the electro-mechanical level or the electrical consumer durable level all of these three companies have done really level. Even V-Guard if you strip down on stabilisers, fans all vertical seem to have done pretty well for themselves. So this is a company that could continue to do well and the valuation gap with Havells could bridge over the next two to three years. Their proportion of non south used to be as low as about 27-28 percent is gone up to about 33-34 percent and that’s grown more than the south markets have.
Discover the latest Business News, Sensex, and Nifty updates. Obtain Personal Finance insights, tax queries, and expert opinions on Moneycontrol or download the Moneycontrol App to stay updated!
