Amid a market environment marked by persistent foreign capital outflows and elevated global uncertainty, mid-cap stocks have staged a sharp recovery, outpacing large-cap peers and raising fresh questions around the durability of the rally. While domestic liquidity continues to act as a counterbalance to external pressures, concerns around valuations, earnings sustainability and sectoral concentration remain central to the debate on whether the current momentum can hold.
In an exclusive conversation with BW Businessworld, Rajesh Palviya, Head of Research, Axis Securities, outlines the underlying drivers of the mid-cap resurgence, the role of domestic institutional flows, and the risks emerging from tighter liquidity and elevated valuations.
Edited excerpts:
Mid-caps have rebounded faster than large caps in the recent rally. What is driving this resilience despite persistent FII outflows?
Mid-cap stocks have shown impressive resilience during the recent rally, outpacing large-cap stocks even with continued outflows from foreign institutional investors (FIIs). The main factor behind this success is strong domestic liquidity. Ongoing systematic investment plan (SIP) inflows, mutual fund investments and increasing retail participation have effectively absorbed the selling pressure from foreign investors. In addition to liquidity, improving earnings visibility and operational efficiency in certain sectors have provided a solid foundation for this recovery, making it more credible than a rebound driven solely by market flows.
Do you think mid-caps are currently benefiting from domestic liquidity more than fundamentals, and is that sustainable?
Liquidity has undoubtedly been the primary driving force in the market. However, a positive development is that reputable companies within the mid-cap sector are increasingly supporting inflows with genuine earnings performance. Consequently, the sustainability of this rally heavily depends on earnings aligning with valuations. Moves driven solely by liquidity, without fundamental backing, often prove to be fragile and susceptible to sudden reversals.
Compared to small caps, mid-caps have higher institutional ownership. Does that make them more vulnerable to global risk-off events?
The answer is complex. While the rebalancing of domestic institutional investors (DIIs) alongside exits by FIIs can increase market volatility, the strong foundation of domestic capital flows today offers significant protection. This has noticeably decreased the intensity of global market shocks compared to previous market cycles. Although higher institutional ownership can heighten sensitivity to market changes, the robust inflows from domestic investors mitigate the severity of these impacts compared to the past.
Where do mid-cap valuations stand today relative to their historical averages and large caps? Are we seeing early signs of re-rating again?
Mid-cap stocks are currently trading near their long-term historical averages, having cooled from recent peak valuations. Although there remains a premium over large-cap stocks, it is no longer at concerning levels. What we are seeing is a selective re-rating of earnings-backed companies, rather than a widespread and euphoric expansion of valuations. This presents a healthier and more sustainable dynamic.
Earnings growth in mid-caps has been strong over the past few years. Do you expect this momentum to sustain, or is a normalisation inevitable?
Earnings growth is expected to moderate as the base effects begin to take hold and the benefits from margins stabilise. However, this should be seen as a normal adjustment rather than a decline. Sectors with strong structural foundations are likely to continue achieving above-market growth, although at a more measured rate. This will maintain the attractiveness of the asset class for medium- to long-term investors.
Are there specific sectors within mid-caps where you see structural growth opportunities versus pockets that look overheated?
Capital goods, industrials, defense, electronics manufacturing services (EMS) and niche financial sectors are emerging as strong growth opportunities, strengthened by supportive policies, robust order pipelines and sustained demand. In contrast, some areas within chemicals, new-age technology and select consumption sectors seem overvalued, with their valuations exceeding expectations for near-term earnings performance.
Is the current rally broad-based within mid-caps, or are returns getting concentrated in a narrow set of names?
The current market rally is not widespread. Market leadership is concentrated in companies that have clear earnings visibility and strong order books, while many mid-cap stocks are still underperforming. This environment is driven by selective fundamentals rather than a general sense of euphoria, which is an important distinction for making informed stock-picking decisions.
With increasing regulatory scrutiny and tighter liquidity conditions, do you see any pressure building on leveraged mid-cap companies?
Tighter liquidity conditions and increased regulatory scrutiny may expose companies with weak cash flows and high debt levels to refinancing risks and margin pressures. Investors should differentiate between businesses that rely on leverage as a structural necessity and those that have overextended themselves during periods of growth; the latter group is particularly vulnerable.
What are your high-conviction mid-cap ideas for the next 2–3 years, and what makes them resilient in a volatile macro environment?
High-conviction opportunities can be found in companies that possess strong balance sheets, competitive export capabilities and clear advantages in their respective sectors. The preferred areas for investment include Power, Utilities, Defence, niche FMCG and Industrials.
These companies demonstrate resilience during macroeconomic volatility due to their predictable earnings, low levels of debt and proven ability to maintain a healthy return on capital employed (ROCE) throughout different business cycles. These attributes are likely to be rewarded significantly over the medium term. |
