Future of Sensex at above 13000

 The recent surge in the Sensex has surprised most market participants. The market has been propelled by strong earnings and renewed flows from FIIs and domestic investors. FII activity has been limited to large-cap stocks. Mid caps have not performed in line with frontline indices.

Over June-October ’06, the Sensex gained 25%, while the CNX Midcap Index gained only 10%. In terms of valuations, most large caps trade at fair valuations, while several mid caps are relatively undervalued. To illustrate this point, the Sensex trades at a P/E of 21.3 times trailing earnings, while the CNX Midcap trades at 17.6 times trailing earnings.

Past experience shows that when mid-cap valuations trail those of large caps by such a large margin, the divergence indicates that mid caps will perform better than large-cap stocks over the short to medium term. We now believe that several mid caps are at levels where valuations are attractive, and valuations may catch up during the second half of the year, as the market discounts their Q3 and Q4 earnings, and future potential.

With India being among the fastest-growing economies, opening up of new export markets and booming domestic demand, coupled with focus on infrastructure spending, will ensure mid-cap companies are on the growth path. Several of them are expected to become large companies in the near future.

The growth potential is higher in mid-sized firms, compared to large companies. The true challenge in investing is to identify mid caps which have the potential to become tomorrow’s large caps. One of the issues in investing in mid caps is their poor liquidity. But recently, mid caps are seeing improved liquidity, though it is still lower than that of large caps.

The other issue is the information flow relating to smaller companies. It is imperative that retail investors have adequate information about the companies they invest in. As the number of mid-cap companies is very large, it’s tough to identify the right companies. A portfolio of carefully-handpicked stocks is an investor’s best course of action.

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