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Mid-cap – Is it still a safe bet?

Aug 31, 2018(17:11)
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Clouds of uncertainty and insecurity are hanging over the mid-cap segment. While almost all the mid-cap stocks witnessed a Midas Touch in the last 3-4 years, most of these mid-cap stocks are on a roller-coaster ride now. Cumulative effects of global, technical and fundamental reasons have led to the tremendous fall.  Each and every piece of the puzzle has to be arranged in a proper way to understand the mishap in mid-caps. Investors were very happy with their investments in mid-cap as the Nifty Mid-cap 50 index surged around 50% last year. Highly progressive measures like the Demonetization and introduction of GST brought a sea change the way investors approached financial assets. They started pouring their money into mid-cap and small-cap stocks. The valuations of these stocks skyrocketed and nobody expected a sudden plunge in 2018.

At the global level, spike in commodity prices like crude oil reaching Dollar 80 per barrel led to an increase in the input costs of the company impacting the profits as well. Not to forget the currency depreciation that severely affected many companies. One after the other cause led the mid-caps to lose their sheen. The hike in interest rates by RBI added fuel to the fire as companies’ financing costs increased thereby shrinking the profit margins.

Rejig that shattered the mid-cap:

Till 2017, there was not much clarity in the categorization of large, mid and small-cap stocks and also on the various types of mutual funds. SEBI made a historic decision that clearly demarked the categories and schemes. SEBI categorized the top 100 companies based on market capitalization as large-cap, the next 101 to 250 companies as mid-cap and the rest as small-cap. This rejig impacted most of the stock prices under mid-cap and small-cap as the AMCs hurried and exited from these stocks so as to realign their fund allocation in accordance to the newly prescribed norms.

Graded Surveillance Measure (GSM) by SEBI added more pain to the mid-cap space. It came out with a list of stocks to alert investors about the abnormal and erratic price movements.  SEBI tightened the noose around these stocks by reducing speculative activity in them. Additional Surveillance Measure (ASM) too has been introduced that caused a severe blow to many of these stocks. Several stocks were covered under this list and these stocks lost investors’ confidence.

Corporate governance issues led to a bloodbath in Mid-cap:

SEBI came with yet another rule in order to bring more transparency and accountability in corporate governance by accepting several recommendations of Uday Kotak committee like enhanced role of audit committee, disclosure of auditor credentials, audit fee, reasons for resignation, etc. This too made investors jittery about their investments in these companies as many auditors resigned.

 

Higher valuations of mid-cap stocks:

Most of the mid-cap stocks rallied for the last 3-4 years wherein some correction was overdue in this space. Despite the weak fundamentals, certain mid-cap stocks were riding on a high wave due to positive sentiment. Companies without strong business fundamentals lost investors’ confidence and were beaten down. The steep price movement and PE differential between large-caps and mid caps has led the latter to underperform in 2018.

Mid-cap Stocks that lost Glory since Jan 15th 2018 to Aug 13th 2018

Investors should avoid or exit from the companies

  1. With frequent governance issues
  2. With Stressed Balance sheet
  3. That failed to deliver free cash flows, minimum RoE and RoCE over a period of time
  4. Whose business model cannot be sustained in the long run

“Knowing when to add to the winners and cut the losers will create wonders in your portfolio”.

Where from here?

Few institutions believe that this wave of correction will continue for some more time. But the difference in the PE multiple between Nifty 50 and Nifty Mid-cap 50 has converged over the past few months, which shows that the mid-cap segment has entered into a corrective phase, post which it may be gearing up for next major up move. Even the BSE Mid-cap 50 has also corrected from the levels of 47 to 32, whereas BSE Large-cap 50 has corrected from 25 to 22.6 levels only. With large-cap indices trading at life time highs, the recent correction in mid-caps offers great opportunity to enter this space and accumulate quality stocks. There are many companies with a strong product line and improved business fundamentals that have not corrected much, indicating mid-cap theme is still alive. Over the last few quarters, the size of the organised economy is expanding at a decent pace which will allow many mid-sized companies to multiply their revenues and profits over the next few years.

PE Multiples from Apr 2015 to Aug 2018

 Key takeaways for investors:

Given the fact that the large-cap segment has lesser tendency to give higher potential returns while the margin of safety is less in small-caps, hence the investors who want to make additional returns need to stay invested in mid-caps for a longer time period. The rate of return for 5 years and 10 years in mid-cap is 25% and 17% whereas the returns from Nifty 50 are 14% and 11% respectively. The growth potential of large-cap companies is limited whereas the mid-cap companies have still enough room for growth which makes them an ideal choice for investment. FIIs focus more on buying large-cap companies which has led to the overvaluation of these companies. The IMF expects India's economic growth to pickup to about 7.3% this fiscal and 7.5% in 2019-20. This will gradually lead to the recovery of mid-cap companies as well.

Quality mid-caps from the sectors or themes like consumption, building materials, consumer durables, technology, financials, pharma and auto can be added to ones portfolio. It is also very essential to enter the market at the right time. For instance, Graphite was trading around Rs.100 per share in 2017 and in 2018 the share price has skyrocketed to Rs.1100. This necessitates a thorough study of the company before investing.

Investors should select top companies keeping in mind the following: 

  1. Dynamic Leadership and good Track Record
  2. Sustainable Business Model
  3. Visibility of Earnings
  4. Correction to a Decent Valuation level
  5. Strong Balance Sheet

 

Mid-cap Stocks that stood the test of time since Jan 15th 2018 to Aug 13th 2018

Over the last few quarters, we have seen a lot of mid-caps reporting strong earnings and they have recovered smartly from the recent mishap. As the saying goes, “Calm after a storm”, this could be the right time to enter the mid-cap space and any correction towards decent valuations can be used to add more good stocks to ones portfolio. The good days are yet to come!

Other Blogs from
Rajiv Singh

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