Bottoms up on mid-cap stocks

Updated: Nov 13 2005, 05:30am hrs
Analysts have always found it difficult to define mid-cap stocks. Most of them agree that there is no scientific method to decide on a mid-cap stock as the whole concept is relative. Some analysts go to the extent of saying that if a stock is not in the top 100 companies in terms of market capitalisation, then the stock is a mid-cap. This probably makes sense considering the fact that the BSE 30 companies account for almost 50% of the entire market capitalisation.

Take for example the CNX Midcap 200 index. It accounts for only 12% of the total market capitalisation on the NSE and against this, the Nifty Fifty stocks account for a whopping 56% of the entire market.

Says Tridib Pathak, CIO, Cholamandalam Mutual Fund: "Firstly, it is very difficult to define mid-cap stocks. One should not generalise on mid-cap investments. These investments are stock specific and are long term. Investors have to wait to maximise their wealth. Since investments have to be long term, it does not really make sense to look at quarterly results and arrive to conclusions. We follow a strict bottom-up approach when it comes to this kind of mid-cap investments."

What is a bottom-up approach Unlike a top-down approach where the economical fundamentals of the country and sector are the first parameters to be considered, a bottom up approach directly deals with analysing the company and its management. To understand the quarterly performance of mid-cap companies, one has to look at the CNX Midcap 200 index. Sales for the second quarter FY 2006, for midcap companies in general show that sales have moved up by 8% and net profits by 20%. On the other hand, large cap companies saw their sales move up by 20% and profits by 14.56%.

The main reason for the difference in growth in profit is associated with the fact that large companies saw expenses growing faster than sales. This was not the case with mid-cap companies. Mid-cap companies saw their operating profit margins move up to 20.48% from 19.78% in the previous year and large companies saw this figure go down marginally to 29% from 31%.


On the other hand, both the Nifty and the Midcap index have moved up by 25% and 27% over the last six months. Companies like Amtek Auto, Munjal Showa and Exide Industries, which belong to the auto ancialliary sector have appreciated by 71%, 58% and 38% respectively. In general, the auto ancillary segment saw its sales move up by 9% and net profit by 6.57%. But that is as far as the auto ancilliary sector in the mid-cap segment is concerned. If one looks at specific companies like Munjal Showa and Exide, the performance surpasses the averages. The half-yearly figures of Munjal Showa show that sales have moved up by 19.25% and profits have moved up by 112%. The same figures for the quarter ended September 2005 show that sales have moved up by 14% to touch Rs 143 crore and profits have fallen by 32% to touch Rs 4.31 crore. This probably shows that mid-cap stocks as a group are very difficult to generalise.

Interestingly, it was the finance and trading sector that has managed to show the maximum growth. Take for example Tata Investcorp. The company saw its revenues grow by 167% and net profits by 139% to touch Rs 68 crore and Rs 66.29 crore, respectively. For the second quarter ended 2005, the securities trading industry saw revenues and net profits move up by 69% and 94% to touch Rs 195 crore and Rs 71 crore, respectively.

This was attributed to the bull run where the BSE Sensex touched the 8000 mark and managed to return more than 50% over a period of one year. This led to increased trading activity where companies like DSP Merrill Lynch, Geojit Financial services and IndiaBulls saw their profits move by 43%, 77% and 230% respectively.

Analysts feel that this is typically a bull market phenomenon and typically may not last for the next quarter as the index has gained by a substantial amount and may not experience a new rally or for that matter attract new investors. In such a situation, much of the securities industry may see its gains stagnating due to lack of trading.


Most of the mid-cap companies are concentrated into four sectors viz computers, textiles, pharma and steel. Take, for example, the mid-cap software segment. Sales have moved up by 20% and net profits by 12% when compared to the corresponding figures for last year. On the other hand, big software companies have managed to maintain their growth rate of 30%. This is despite the fact that revenues per employee have been falling for the larger companies.

Infosys and TCS, the two major software companies saw their revenues fall to Rs 4.96 lakh and Rs 5.59 lakh, respectively.

Much of the reason was attributed to the fact that there has been a high attrition rate in the industry where companies have lost experienced people and had to replace them with fresh graduates and train them. Correspondingly, the retention costs have gone up in the industry. This, coupled with the increase in the employees, added to the fall in the per employee revenue which also squeezed margins.

Take for example iGate Global Solutions. For Q2 FY06, revenues have moved up by 5.6% and net profits by 296% to touch Rs 155.77 crore and Rs 5.62 crore respectively. The company was making losses and it has turned around in the past few quarters. The high growth in net profits reflects the lower base of the company.

At the end of September 2005, the total employee strength of the company was 4356 employees and the company has added only 73 people in the second quarter. On the other hand, bigger companies like Infosys saw the total strength go up by 40% over the last one year. For TCS the same figure stood at 30%. Infosys has added 8026 employees and TCS has added 5596 employees during the same period.

Says an analyst in a leading broking firm "Large cap companies may manage to record higher growth in sales. But at the cost of rising expenses. Expenses for large cap companies have risen faster than sales. That is not the case with mid-cap companies. Most of the companies have low operating expenses based on their operational scales."

Large cap companies had to face expenditure from various aspects. Higher oil prices and interest costs took a toll on large companies. ONGC saw its interest cost go up by 140%. Most companies have gone in for loans as a means of finance on acccount of lower interest rates in the recent past. But as interest rates start to move northwards, the costs are galloping. In 1984, UK went through a phase that was similar to what is happening to India. It was the time when the mid-cap segment was outperforming, property prices were rising and people were spending money. But then it was the crash of 1987 which affected the world market and it took some time for the UK markets to revive.

Right now, the mid-cap sector has managed to show a decent corporate performance. But since analysts follow a bottom up approach for the sector, the findings are not conclusive. Let's not generalise on mid-cap investment.