India Midcap Companies

Via Business Standard

Mid-cap stocks are in the news. Here's why you should jump on to the bandwagon. Benefits of diversification between different asset classes are well known. Putting all your eggs in one basket, be it stock market, real estate or fixed income is risky. It may lead to high volatility as well as under-performance of the portfolio in long run.

In the same vein, once it’s decided what portion of your portfolio needs to be invested in equities, you should further diversify within this asset class. A good diversification would include investing in different stocks based on sectors, type (growth vs value) and market capitalisation.

Similarly, it’s important to balance between growth and value stocks (simply put, high price-earnings (P/E) multiple vs low P/E multiple high dividend stocks).

Companies are differentiated on the basis of their size into large, mid and small-cap stocks. Some of the examples are Reliance, HDFC and SBI (large-caps), SKF India, Arvind Mills and Mphasis BFL (mid-caps) and Natural Capsules, Indian Toners etc (small-caps).

After the market correction in May 2006, the subsequent market recovery was restricted to large-caps alone till January 2007. Most of the mid-caps remained at the depressed May 2006 levels and had hardly moved.

Over the last couple of years, mid and large-caps have rallied one after the other with only a couple of months at maximum separating one from the other. If, large-caps rally from May to July, mid-caps would follow by August or September.

This time, the gap between rallies in the large and mid-cap classes has been of around eight-nine months and probably the longest in recent times. This year, the mid-cap index has rallied for the past few months. For example SKF India, after spending nearly 12 months hovering around the price of Rs 300, suddenly moved to Rs 480 from April beginning to May end—a 60 per cent return in just two months.

If we look at the recent past at the stock market in general, the large-cap CNX Nifty as of June 1, 2007 has given a three-year annualised return of 42 per cent.

This performance gets slightly better, if we consider last one year returns at 45 per cent. Compare this with CNX Midcap returns of three years and one gets a similar figure of 43 per cent. And in the last one year, the return has been to the tune of 33 per cent.

Sure, if someone invested with a one-year horizon, he would have been better off in large-caps. But over three years, the returns are more comparable. Over a longer period, the difference could be far larger. But since in India, we do not have very long period data on mid-cap indices, let’s visit a study done in the US.

In 2005, US research firm Morningstar released a report on returns generated by mid-caps vs large-caps in the US over a period of 30 years from (1975 to 2005). According to the report, Every dollar invested in large-cap stocks in 1975 would be worth $32.7 in 2005 vs $65.3 in mid-cap stocks! That’s more than double. The CAGR stands at 14.9 per cent.

If we look around us in India, common stock market millionaires are those who invested in HLL in the seventies, Reliance in the eighties, Infosys in the nineties and Bharti in 2000s and held them. Dr Reddy’s, Cipla, Asian Paints and most of today’s large-caps too fall in that category. These were mid-caps not too long ago. These stocks are unlikely to make you millionaires if you were to enter now.

Consider the following points before you make a judgment call on mid-caps: In any time frame of investments, both categories will have some losers and some winners. Large-cap HLL has lost 15 per cent over the past year.

Given the fact that large-caps have rallied during the same time by 45 per cent, the opportunity cost for the HLL investor is 60 per cent (45 per cent lost in not buying the index and 15 per cent lost on account of holding HLL.

Stocks of sunrise industries will mostly be mid-cap stocks in their early phases. For example, the information technology industry, the mainstay of our services industry as well as exports today, was a sunrise sector in early nineties.

The mobile telephone industry was similar in early 2000s. Big money making opportunities were available to investors through only mid-cap companies in these sectors.

Only later, companies in these industries, after passing through volatile and testing times prove their worth and move up the next level–the world of large-caps.

Today, we could possibly classify media and healthcare sectors in this category. Healthcare need is rising in the country. Rising population and stressful lives are fuelling this demand.

Besides, most of the Indian pharmaceuticals companies have a robust export business. In media, there is strong demand for both print and television as penetration increases.

However, like Infosys in IT or Bharti in telecom, it’s difficult to name a single company that would represent healthcare or media in the future. Some companies are taking small steps to get there – are they large-caps in the making? We do not know. But surely one can say that there will be some companies which will emerge as market leaders in the next decade. Picking that winner is the challenge.

But then there are drawbacks to investing in mid-caps we well.

# Expect volatility in the initial years
# Unknown management
# Cost of borrowing is higher so their balance sheets take bigger hits in terms of interest payout etc
# Low liquidity, especially if markets turn negative

The two most important factors that will determine your financial health in the mid-cap universe are good research and lots of patience. If your investment time horizon is long, this segment of the equity markets is definitely a must have in your portfolio for keeps.