Mid-cap themes for 2014: Is it time to buy mid-cap stocks?

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BSE-500 Index constituent companies, excluding those that are also in the Nifty, have an average debt-to-equity of almost 130%. Reuters BSE-500 Index constituent companies, excluding those that are also in the Nifty, have an average debt-to-equity of almost 130%. Reuters
SummaryMid-caps have significantly lagged large-caps, with BSE Mid-Cap index underperforming Sensex...

Six years of underperformance

Over the past six years, mid-cap companies have significantly lagged large-caps, with the BSE Mid-Cap index underperforming the BSE Sensex by 4,000 basis points. Investors have become risk averse from 2008, preferring larger companies to their smaller counterparts. This shift in investorsí focus from small to big was driven by concerns over high leverage and poor corporate governance among mid-cap companies.

Indeed, while the average debt-to-equity of the 50 companies in the NSE Nifty Index is currently around 72%, the BSE-500 Index constituent companies, excluding those that are also in the Nifty, have an average debt-to-equity of almost 130%. Although mid-cap companies in the long-term deliver better returns than large-cap, they typically tend to underperform during down cycles.

The case for investing in midcap stocks

The mid-cap index has severely underperformed the large-cap index in the past few years, resulting in a high valuation gap. Currently, the mid-cap index is trading at a 39% discount to the large-cap index. Although mid-cap companies offer better returns in the long term with a slightly higher level of risk and there is wide valuation differential between mid-caps and large-caps, we expect large-cap stocks to outperform in the near term. In our view, 2014 is likely to continue to be painful for smaller stocks as uncertainty over QE tapering and the coming general elections keep investors biased towards low beta trade.

Time for a reversal?

Our economist believes the RBI is likely to raise the policy rate further in 2014, as inflation pressures remain. Given that leverage rises quite dramatically from-large-caps to mid-caps, this hardly makes the case for investing in mid-caps compelling. On the other hand, foreign institutional investor (FII) holdings in mid-cap stocks have fallen consistently over the last six years. QE tapering by the Fed is also likely to have a bearing on capital flows into emerging markets and it is difficult to envisage excessive inflows into Indian equities in such an environment. In our view, though their valuation gap with large-caps has widened, mid-caps lack material fundamental catalysts to stage a broad-based turnaround.

Three key themes for 2014

Investors who choose to look at mid-caps in 2014 should adopt a selective approach based on the following three key themes:

(i) Relative insulation from leverage-related stress. Given our expectation that policy rates will remain high in 2014 on the back of sticky inflation, we would be cautious on

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