Know When Midcaps Outperform

A successful self trader – Rule # 7

A mid-cap stock is hard to define, but there are some standards set. Globally, it’s a mid-cap stock if it has a market cap between $2 billion and $10 billion. The relevant numbers in India will be obviously smaller. These mid-cap stocks become important because they constitute a much larger share of trading volumes; disproportionate to their size. And retail interest in mid-cap stocks is huge.

Getting your mid-cap strategy right…

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 01st 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 the 1990s, the pharma industry in India was dominated by the 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 me 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 and in emerging sectors. Lastly, as they mature into large caps, they tend to get re-rated, resulting in value explosion!

3 CLASSIC ADVANTAGES IN THE MID-CAP STORY:

Focus, Focus, Focus…

While the Tatas, Birlas, Khaitans and Ruias could diversify into sundry areas, an 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.

Could be the large caps of tomorrow…

That is the salivating possibility. A bet on Infosys at its IPO in 1994, will 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!

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

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 mid cap stock 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 of 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 the 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 mid cap 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 of 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 the Nifty from August 2013 onwards. Mid caps 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.

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, 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 but 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, Eicher, Motherson Sumi, Bharat Forge and Britannia have little to worry about the macro twists and turns. Remember stocks like Aurobindo, Motherson and Eicher gave multi-bagger returns at a time when the overall markets were going nowhere. That hedge could be the biggest argument in favour of mid caps.

One response

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: