know when midcaps outperform

Topics Covered

• 1. Getting your mid-cap strategy right
• 2. CLASSIC ADVANTAGES IN THE MID-CAP STORY: Focus, Focus, Focus
• 3. Could be the large caps of tomorrow
• 4. Smaller capital base is an advantage
• 5. 6 INDICATORS TO WATCH OUT FOR IN MID-CAP STOCKS
• 6. THE UPS AND DOWNS OF A MID-CAP STRATEGY
• 7. TAKEAWAYS FROM THE "MID CAP STOCKS" DEBATE

As per SEBI's classification, the companies from rankings 101 to 250 in terms of market capitalization are known as mid-cap companies. Their market cap generally tends to range from Rs. 5,000 to Rs. 20,000 crore.Mid-cap stocks are important because they constitute a much larger share of trading volumes; disproportionate to their size. Also, retail interest in mid-cap stocks is huge.

1. Stock selection is still an issue in Equity SIP

If you want to understand the importance of mid-cap stocks, just look at the NSE CNX Mid Cap Index. Launched in 2005 with a base date of January 1,t 2003 and a base value of 1000, this index has grown around 13 times during this period. The frontline Nifty has grown a little over 8 times during the same period. This outperformance lies at the core of why mid-caps need better understanding.

Back in the 1980s and 1990s, the pharma industry in India was dominated by home-grown companies like Cipla, Ranbaxy and Dr. Reddys, apart from the MNCs. Back then, Sun Pharma was a low profile mid-cap company that focused purely on specialty generics. With focused acquisitions, Sun Pharma today has a market cap that is more than the original big-3 of Indian pharma combined.

That brings us to the 3 distinct advantages of mid-cap companies. Firstly, they are focused on their core business, more by default, as they do not have the resources to spread themselves thin. Secondly, they are more likely to be professionally managed in emerging sectors. Lastly, as they mature into large caps, they tend to get re-rated, resulting in value explosion!

2. CLASSIC ADVANTAGES IN THE MID-CAP STORY: Focus, Focus, Focus

While the Tata’s, Birla’s, Khaitan’s and Ruia’s could diversify into sundry areas, Infosys or Sun Pharma could never afford that luxury in the 80s and 90s. Probably, more by default, they were forced to focus on their core business.

3. Could be the large caps of tomorrow

That is the salivating possibility. A bet on Infosys at its IPO in 1994, would have resulted in a crazy multi-bagger, even after the tech meltdown. And a Hero Honda, without the historical baggage of Bajaj, did wonders in two-wheelers!

4. Smaller capital base is an advantage

How could a stock like Eicher appreciate 150 times in 5 years? Quality companies with low capital base and limited floating stock have a natural advantage. A good story ensures that prices can move just one way. Oh, didn’t we see that?

"Small companies with strong cash flows are great assets if bought at the right time and the right price" – Peter Lynch

5. 6 INDICATORS TO WATCH OUT FOR IN MID-CAP STOCKS

1. A quality mid-cap story is one which is constantly making improvements to its market share as well as to its profit margins. Any stock broker that is showing consistent fall in market share or consistent erosion in margins is a test case for a re-look. Either it is losing the technology race or the pricing war!
2. Most mid-cap companies have a disproportionate reliance on a couple of product lines or on a handful of customers. This is especially true for auto-ancillary companies which are dependent on 1 or 2 auto manufacturers. If you sense problems in these product lines or customers, time to watch out!
3. If a mid-cap company is in a commodity business, then watch out for the cycles and super cycles. When the steel cycle turned down in the 90s, scores of small steel producers went out of business. This is also typical of agro-based companies which are also vulnerable to super cycles.
4. Keep a tab on what insiders are doing in these mid-cap stocks. Are the insiders picking up stocks at lower prices? Are institutions consistently downsizing their stake in the company? How is promoter stake moving? Himachal Futuristic was a classic case of promoters exiting gradually.
5. Look out for the valuation metrics and ensure that it is in sync with future growth. A midcap stock trading at a P/E of 30-35 is nothing alarming. It is most likely factoring in future earnings growth. But if the P/E is out of sync with downgraded growth projections, then alarm bells should start ringing.
6. Look out for froth in the mid-cap space. There are quite a few indicators. Falling delivery volumes show that traders have taken over a stock. Too much stock futures build-up is a sign of arbitrage funding. It is not sustainable. Also watch out if volatility of the stock price starts fluctuating wildly!

THE UPS AND DOWNS OF A MID-CAP STRATEGY

Remember the old market saying, "You make money in mid-caps and store money in large caps". In any rally, mid-caps display some unique features. Firstly, mid-caps are late to join any market rally, but they more than make up with their pace and ferocity. Look at the rally in Nifty from August 2013 onwards. Midcaps virtually started participating only from mid-2014, although they made up with their fleet-footedness.

There are also some unique characteristics of mid-caps in a market downturn. They are normally the first and the hardest to get hit. In the carnage of 2008, most mid cap stocks gave away 90% of their value by the time large caps had given up to 50% of their value. Also mid-caps are very susceptible to liquidity issues. Tightening of rates by the RBI, higher margins and margin calls by brokers, higher haircut in funding can all be negatives for mid-cap stocks.

Recommended Read: How to choose stocks for intraday trading?

TAKEAWAYS FROM THE "MID CAP STOCKS" DEBATE

As investors of the stature of John Templeton and Peter Lynch have consistently maintained, there is a lot of value and money to be made in mid-caps. One just needs to read the right story, bet on the right prospect and manage risk judiciously. Remember that stocks like Hero Honda, Bharti Airtel, Infosys and Sun Pharma were all mid cap stocks at one point of time. It is their focus, aggressive marketing, appropriate positioning and professional management that converted them into valuable large caps.

You will be surprised to know that the NSE Mid-Cap index contains many more non-cyclical companies than the large cap Nifty. The high weightage stocks in the mid-cap index like Aurobindo Pharma, Eicher Motors, Motherson Sumi, Bharat Forge and Britannia have little to worry about the macro twists and turns. Remember stocks like Aurobindo Pharma, Motherson Sumi and Eicher Motors gave multibagger returns at a time when the overall market was going nowhere.