Is there a case for investing in mid-cap shares in the current market?

To understand the power of mid cap stocks one needs to look at their performance in the year 2015. During the year, the Sensex and Nifty lost about 5% value. That was largely due to cheap oil prices, worries over Chinese slowdown and a fall in commodity prices worldwide. But in contrast, mid cap companies actually gained 6% over the year. A lot has changed since then. In the month of January 2016, mid cap stocks fell nearly 10% and their fall was much sharper than the Sensex and Nifty. That has raised serious questions over the sustainability of mid cap stock valuations. It also begs the basic question; does it make sense to buy mid cap stocks or is it better to stick to large cap stocks only.

We believe that there are 3 key reasons why mid-caps could be a compelling play after the sharp correction in January. In fact, if anything the correction may have given an attractive entry point into these stocks.

They are the actually beneficiaries of cheap oil and commodities…

If you look at the large cap companies, their problems are typical. The FMCG segment is suffering due to weak rural demand. The banking sector is suffering due to an overload of NPAs. The capital goods sector is suffering due to weak revival in the capital cycle in India. Oil producers are down due to obvious reasons, just as steel and aluminium producers are. The moral of the story is that most large cap companies tend to lose out in a scenario of cheap oil and commodity prices.

On the contrary, the mid cap companies are actually beneficiaries of cheap commodity prices. Being highly capital-intensive in nature, there very few mid cap companies in sectors that tend to lose out due to cheap commodity prices. For the mid-cap companies cheap oil and commodities are actually dividends which reduce their cost of operation substantially. That is what makes these mid-cap companies attractive in this scenario

Mid caps are less leveraged compared to large caps…

The current market situation is such that there is a great premium on low leverage. Most large business houses tend to be overly leveraged. Mid-caps have neither access to huge funds nor do they require leverage. This ensures that their ROE is relatively high and this ensures that the low financial risk translates into robust growth in earnings. Look at the early indications that are coming in from Q3 results. More than 55% of the mid cap companies that have announced results in Q3 have reported EPS growth that is higher than their 5-year average. This puts their growth in a new trajectory for the next five years.

Their business models are more focused…

Most mid cap companies are typically driven by entrepreneurs. Hence by design their business models tend to be more focused and lean. They cannot afford to raise huge capital and diversify into a variety of areas. This ensures that they keep their capital base small and hence their ROE is normally higher than the large cap companies.  Look at some of the outperformers of the last 4-5 years. They are all mid cap companies that have had a very clear focusing. Lupin focused purely on the generics market and saw its market cap multiply by 6 times in the last 4 years. Britannia focused on the premium business segment and saw its market cap grow by 8 times in the last 4 years. Of course, stocks like Eicher Motors with a strong focus on motorcycles have seen their market cap appreciate over 100 times in the last 7 years. The value coming from focused business models can only come from mid cap companies! That is why they continue to be value for money.

So what should be your strategy post this correction? The sharp correction in January is an exciting entry point into mid cap stocks. Look at stocks that have corrected sharply but their earnings growth and ROE is intact. These could be the value pockets for you to focus on. For the first time in 2015, the mid cap stocks actually moved in contrast to the large caps. This has ensured classic outperformance. This is just the beginning. If you are looking to create value over the next 5 years, the real value could actually lie in mid-caps. That is where investors need to focus on. Large caps can at best give you good trading opportunities in the market.

You can ask us your stock related questions with #AskReligareOnMarkets via our Twitter channel @religareonline

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