Year 2022 was a rather sombre year for the markets. After rallying 24 percent in 2021, the Nifty 50 is on track to deliver flat to marginally positive returns this year. Meanwhile, the Nifty Midcap 100 is set to close the year in the red. Its underperformance, compared to the 46 percent rally in 2021, is very stark.

High inflation, tightening monetary conditions and fear of recession in the US and Europe have bogged down equities. Despite this, the Nifty managed to scale past its previous all-time high and touch a new peak of 18,887 on December 1.

On the other hand, the Nifty Midcap 100 is still over eight percent away from the peak of 33,243, hit in 2021.

So, is 2023 set to be the turnaround year for midcaps? Let’s take a look at some data points.

The valuation picture

Despite a lot of froth being taken out in 2022, midcaps are still expensive. While the Nifty 50 and the Nifty Smallcap 100 are trading at valuations a tad higher than their 10-year averages, the Nifty Midcap 100 is at a significant premium of 30 percent to its long-term average.

 

“In the next six months, we expect a 10-15 percent correction in midcaps, which should make valuations more reasonable to buy,” Niket Shah, who manages Motilal Oswal’s Midcap 30 Fund, told Moneycontrol.

 

Currently, the midcap index is trading at around 25 percent premium to the Nifty 50. This premium has sharply declined from the COVID-hit period of June-August 2020, when it had reached 60 percent.

 

So, the second half of 2023 is when the real midcap magic will begin, Shah believes. “By then, all high-cost inventory will have been liquidated, inflation would have cooled off significantly and central banks would then start cutting interest rates to propel growth,” he added.

According to him, the midcap index’s PAT (profit after tax) will grow 15-16 percent in 2023, which is 200 basis points higher, compared to 13 percent PAT growth estimation for Nifty 50.

The returns picture

Data from the past 20 years suggest that the Nifty Midcap has outperformed the Nifty 50, two-thirds of the time with the average outperformance being 8 percent. If we look at the last 10 years, the midcap index has outperformed the Nifty 50 by 25-30 percent.

Similarly, the last 3-, 7- and 10-year CAGR of the Nifty Midcap, at 24.6 percent, 14.2 percent, and 14.5 percent, respectively, have been higher than the Nifty’s 15.7 percent, 13.5 percent and 12.1 percent, respectively.

 

“What will work in favour of midcaps despite higher valuations is that earnings growth in FY24 for a majority of companies will be well in excess of 20 percent, gearing ratios are less than 0.5x and ownership of domestic mutual funds and long-only private equity funds is large,” said Jaspreet Singh Arora, CIO, Research & Ranking, a SEBI-registered investment advisory.

As per global brokerage firm Jefferies, the earnings growth of the Midcap index, at 15 percent, has already outpaced that of the Nifty at 7 percent this year.

Stocks and sectors to watch out for

Bloomberg data suggests decent expansion in return on equity (RoE) for midcaps in the next financial year. On an average, one can expect about 100 basis points of RoE expansion.

Like largecaps, banks remain the hot favourite in midcaps, too. On the back of an increase in capital expenditure and cleaning-up of bad loans on their balance sheets, mid-cap banks like Canara Bank, AU Small Finance Bank, and IDFC First Bank have seen a jump in their Q2 net profit numbers. Fund managers believe there are more legs to the bank rally.

Domestic-facing sectors, like cement and capital goods, are the next big favourite.

“The country is now truly moving towards the Make-in-India theme. We are seeing significant demand traction in most of the cement companies,” said Shah. According to Bloomberg, Ramco Cements’ RoE is set to expand from 5.98 percent in FY23E to 10.38 percent in FY24.

Auto ancillary companies, like Balkrishna Industries, MRF and Bharat Forge, are also set to see an RoE expansion. “Auto and auto ancillaries will see volume normalisation in 2023. However, their valuations might be a bit too expensive for an investor’s liking,” said George Thomas, Fund Manager-Equity, Quantum AMC.

“There are many chemical companies in the mid-cap space but their margin expansion has already played out,” he added. Tata Chemicals is set to see a 100 basis-point contraction in RoE and Deepak Nitrite might see a modest RoE expansion by 78 basis points, as per Bloomberg.

Some smaller companies in the mid-cap space might not see any improvement in return ratios, believes Divam Sharma of Green Portfolio.

“We do not expect a sudden rise in the RoE metric as companies might retain their earnings in order to cushion themselves for the next capex cycle. As they clock higher net income, the growth in RoE will only witness modest growth as they reinvest the profits in the business rather than paying dividends,” explained Sharma.

On the other hand, fund managers and analysts remain wary of external-facing sectors like IT and pharma that derive a large part of revenue from the US and Europe.

For Jefferies, some key ‘buy’ calls include TCI Express, Thermax, Supreme Industries, Crompton Greaves, Dixon Technologies, CMS Info Systems, Aavas Financiers and Devyani International.

So, the bottom line is midcaps could outperform largecaps in 2023, though the margin of outperformance might be small due to the valuation gap. What can spoil the setup for this outperformance is investors taking safety in largecaps, if macroeconomic challenges persist, and inflation remains above the central bank’s tolerance band and equity markets continue to be volatile.