Indian mid and smallcap indices are down 27 percent and 41 percent, respectively, from their highs in January 2018. From a premium of over 50 percent to Nifty, midcap valuations are now at an 18 percent discount, according to a report by Edelweiss. This level of valuation discount is close to historical lows of 2011 and 2014 and, in some sense, it lends comfort that the downside to their valuation multiples can be limited, it added.

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Majority of the correction so far in the space has been led by a fall in valuation multiples, while downgrade in earnings has been only mild. Since September 2018 when the liquidity crisis started, the Nifty Mid-cap 100 Index’s FY20 earnings downgrades have averaged only 11 percent, the report stated. Given that in Q1FY20 mid-cap earnings fell 5 percent, the annual consensus of 15 percent growth seems optimistic and entails 20 percent growth in balance FY20, it added.

Digging deeper, the report also points out that two-thirds of the mid-cap 100 stocks have seen earnings cuts of less than 15 percent in the past one year.

Studying the past bull phases (primarily 2003-08 and 2013-18), the report highlights that returns in the first year of market rallies are extremely critical for overall return CAGR of bull phases. For instance, during August 2013-January 2018, the mid-cap index returned 30 percent CAGR but excluding the first year's returns of 69 percent, the CAGR falls to 20 percent. The brokerage said, it sees a similar trend of dominant first years in other previous bull phases as well.

Meanwhile, the past reversals indicate that stocks that rally the most in the first year have earnings per share (EPS) growth expectations of over 15 percent for the subsequent year and stock price decline at least 15 percent in the preceding 12 months. They note that after a sharp market correction, about half of the stocks that meet these criteria generate returns in the subsequent year.

With that in mind, the brokerage's stock picking framework attempts a blend of:

1. Winners: High-quality businesses with long-range structural growth opportunities. Potential winners can also be companies that will see significant profitability and return profile improvement in the next two-three years, it said.

2. Slowdown warriors: Businesses that not only show resilience in slowdowns and shocks but also emerge stronger from slowdowns.

3. Value: Deep value plays which may re-rate when the market becomes risk-on and companies benefitting from a significant industry structure change.

With the report, Edelweiss launched a model portfolio comprising 22 top picks in this space. Eleven of these ideas are as 'winners' and they allocate 50 percent weight to this category. 'Slowdown warriors' get a 16 percent allocation, with Voltas as a leading pick in the category. Within this portfolio, their highest conviction picks are Voltas, Apollo Hospitals, Spice Jet, Mindtree and Sobha.

Here are the top mid and smallcap picks from the brokerage:

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