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Suresh Krishnamurthy

The superior valuation of large-caps is more indicative of stable and lower returns than expectation of superior growth. In this context, a continuing rise in the price of many large-cap stocks needs to be viewed as an opportunity to sell.

THE expectation from large-cap stocks is significantly higher than from mid-cap and small-cap stocks when it comes to required earnings growth needed to deliver reasonable returns.

Large-caps trade at a premium to mid-caps; and mid-caps, in turn, trade at a premium to small-caps.

The bias is not unwarranted. In terms of their earnings and cash flow growth record, large-caps usually have, generally, performed better than mid-caps, and mid-caps have done better than small-caps. Nevertheless, the premium valuations require large-caps and mid-caps to continue their superior growth performance over the next five years.

Consider the required earnings growth for the different segments of the market:

Large-caps (stocks with a market capitalisation of more than Rs 5,000 crore): Over the next five years, the required earnings growth is 27 per cent, on an average. This is significantly higher than the 18 per cent growth recorded so far.

Wipro, Infosys, Ranbaxy, Tata Motors and BSES now require more than 35 per cent growth in earnings in the next five years. And earnings in IOC, Neyveli Lignite, Tata Power, Hero Honda Motors and MTNL need to grow less than 15 per cent.

Mid-caps (stocks with a market capitalisation of between Rs 1,000 crore and Rs 5,000 crore): These stocks require earnings growth of about 25 per cent, on an average.

Again, this is significantly higher than the 13 per cent growth rate registered in the past five years.

Companies such as Glaxo Smithkline Pharma, ACC, Bharat Forge, Cadila Healthcare and Gillette require earnings growth of more than 35 per cent, while Moser Baer, Great Eastern Shipping, Tata Chemicals, Dredging Corporation and Raymond need to notch up less than 15 per cent.

Small-caps (stocks with a market capitalisation of less than Rs 1,000 crore): These stocks require earnings growth of only about 12 per cent. However, their performance so far has also been dismal. Average earnings growth has only been about 8 per cent.

Small-cap stocks such as CESC, Titan Industries, Birla Corporation, Elgi Equipments and Whirlpool of India now require significant earnings growth of more than 35 per cent.

Small-cap stocks such as IPCA Labs, Marico Industries, TNPL, Gujarat Mineral Development and JB Chemicals require earnings growth of less than 15 per cent.

The difference in performance of large-, mid- and small-caps extend to cash-flow growth too. Large-cap stocks have generally had much more stable cash flows while small-caps fare the worst in terms of cash-flow performance. This is reflected in the cash-flow growth required too.

Small-caps have to turn in a much better performance on the cash-flow front compared to mid-caps and large-caps. For the latter two, cash-flow growth only has to keep pace with earnings growth.

However, for small-caps, the required cash flow growth is nearly 50 per cent more than the required earnings growth.

Superior valuation, lower returns: The higher earnings growth required from large-caps may not necessarily mean these stocks are over-valued compared to mid- and small-caps. Large-cap stocks may be better able to exploit the opportunities that a growing economy may provide.

In addition, they may also have the cash-flow strength to pursue growth by buying into mid- and small-cap companies. Large-cap companies are also exposed to other economies. So, a recovery in growth of the global economy will also benefit these companies the most.

On the contrary, a growing economy provides opportunities for all companies to grow. In this context, mid-cap and small-cap companies too can prosper. Given their small base, the latter's growth rate will also be faster.

Overall, however, the superior valuation of large-caps is more a reflection of the possibility of stable and lower returns than any expectations of superior growth. In this context, a continuing rise in the price of many large-cap stocks needs to be viewed as an opportunity to sell. In contrast, large returns appear likely only from mid- and small-caps.

More specifically, the difference between the sustainable growth rate and required earnings growth highlights the possibility that small-caps may out perform both large- and mid-caps. This is because:

The sustainable earnings growth rate for large-caps is 15 per cent while the required growth is 27 per cent.

For mid-caps, the sustainable growth is 11 per cent while required growth is 25 per cent.

In contrast, the sustainable growth is 10 per cent while required growth is 12 per cent for small-cap stock.

The difference in the case of small-caps may be more easily bridged, and small-caps hold the potential to deliver reasonable returns. This is in line with historical trends. Small-caps as a class have outdone both mid-caps and small-caps in the last six years. However, the higher returns may be seen as compensation for the higher risk involved in investing in these stocks.

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