For the last couple of years, it was about playing the Nifty. Buying and holding a Nifty-based portfolio was the best and easiest strategy for most investors in Indian markets.
Thanks to FII interest, index investing became one of the best strategies that delivered. For most of the diversified equity funds, beating the Nifty was their target and those who managed it could do so by chasing the highly-risky hot sectors.
Nifty, being a diversified index, was seen as a better risk-adjusted way to take an exposure in Indian markets by institutional investors.
Mid-cap saga
When too much money chases too few stocks, exit becomes somewhat painful.
The same is being experienced now. Ban on participatory notes in Indian markets and subprime woes in the US have bought in some selling pressure resulting in a depressed Nifty. However, on the other hand, the mid-cap indices are showing upward movement as marketmen observe, ?There is a lot of value in the mid- and small-cap stocks.?
The movement in the mid-cap is not a recent phenomenon. In fact, the CNX mid-cap and Nifty have shown almost similar performance this year.
Domestic mutual funds have for long recognised the potential of tomorrow’s leaders and launched dedicated mid-cap funds.
To add to these mid-cap offerings, there are some diversified equity funds allocating a part of their assets to mid-cap stocks. As a result of such flow towards the mid cap segment, the space has hogged the limelight. The demand for such stocks has gone up, pushing up their prices. With more and more fund houses coming out with such offerings, it becomes all the more imperative to consider such stocks. Though such expert aid is available, there are many who would like to take their plunge into this segment.
Worldwide, no equity portfolio is complete without the inclusion of mid-cap stocks. Mid-caps and small-caps are perceived to be tomorrow’s wealth creators. But there is no concrete definition for a mid-cap stock or small-cap stock.
Some consider market capitalisation as the yardstick. And consider stocks whose market cap is below the highest observed in the CNX Mid-Cap index. Small-caps, on the other hand, are typically those that have a market capitalisation of less than Rs 1,500 crore. Mid-cap investing works on the principle of ?high risk and high return.? The urge to beat the market, creation of alpha, leads to finding such counters where an outperformance to the broad sector is possible. However, the game is not as simple as it looks like. There are some factors that must be analysed in greater detail.
Industry preferences
The top-down approach to investing allocates higher weightage to the industry analysis than anything else. If you can find out the booming industries offering good future in the foreseeable future, half the work is done. The industry analysis throws light on the investment potential in the market.
However, attractive industries need not be the ‘hot’ industries on the bourses. Rather, if you come across something that market participants do not recommend but offer huge growth coupled with low-risk, it is worth considering. Experts reckon that there are some opportunities in the export-oriented sectors. For some time now, the textiles, auto ancillaries, pharma and IT & ITES has not been doing well. However, in the mid-cap space, there are many opportunities you may come across, where a patient investor can make good money. Private equity flowing in such counters with a long-term view is an indicator of such opportunities.
Management quality
Good managements can turn mediocre businesses into great wealth creators while mediocre managements turn great businesses into wealth-destroying ventures. Management is the key to business successes or failures. Ability of the management must be considered before investing in such companies. Mid-cap counters are typically under-researched. Hence, it becomes imperative that you ponder not only over the management’s ability to create wealth but also to share it with the shareholders. A management that has stood by its guidance and delivered over in the long-term should be preferred over newcomers. Companies that outperform the broad sector performance should offer good investment opportunities. The managements of such companies should also be active on some non-business related issues. These typically include creating of liquidity in the counter by way of stock split and bonus along with a market for their shares.
Scalability
Investors should buy mid-cap shares that are likely to emerge as frontrunners tomorrow by scaling up operations to match industry leaders. There is a need to find out businesses where operations can be scaled up in the short and long terms. There are instance where the bargains are good although opportunities in a sector are limited such as business models that cater to niche segments but are not capable of exploring new markets and offering new products.
Only companies that can add capacities and expand businesses in the right direction at the right time and at minimal cost can deliver handsome returns to their shareholders.
Earnings and price
At a time when India is in the ‘building mode’, there are burgeoning order books; there are some sectors and companies offering good earnings visibility. In any investment, the price of a security is important. ?It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price,? observed legendary investor Warren Buffet.
The price you pay for the counter will decide how much you are going to make or lose if you have got it right or wrong. In the bull market, we are witnessing in recent times, it is important to pay heed to the price one pays. Markets reward only those who can pick a stock at a price that offers a good margin of safety.
Concerns
Even If an investor gets it right after sifting through the large gamut of almost more than 1000 stocks, there are some risks that need to be kept in mind before committing funds.
Being under-researched, an investor may not have adequate information on mid or small cap companies. It will be prudent for investors not to base their investment on assumptions as they may not be the reality. “When in doubt, remain out,” say the marketmen. It may cost a few extra bucks by entering late but by not doing one’s homework, an investor may lose heavily.
A business that uses high leverage is good in times of good growth and lower interest rates. However, in the long run, as the company’s growth slows, in a high interest regime, losses are likely to be heavy for investors. Due to cheap and instant funds, companies can come up with highly-leveraged balance sheets. Under such circumstances, a ?due discounting? needs to be done. There are some small companies that opt for foreign currency loans. Due to depreciating US dollar and falling interest rates in the US in recent times, the overall picture looks great and the interestcosts are expected to go down. This has pushed up their bottomline, indicating a high earnings potential. But investor must consider that interest rates and currencies may move the other way round.
Liquidity and situations
Mid-cap and small-cap counters are risky due to low trading volumes. If an investor sees a great investment opportunity at a throwaway price, he should be careful as exit is more important than entry.
Low liquidity can make the exit painful. There are instances where selling leads to losses, especially when there is a mass exit. As earlier noted, you must keep a track of the management if it is keen to ‘create’ volumes in counters.
There are special situations where one may ride the mid-cap and small-cap wave. Frequent changes in the rules of the game may make some counters attractive. Take the case of the banking sector.
There are small-sized banks, both in public sector and private sector, that are slated for takeovers post March 2009 when the sector further opens up.
However, one must note that any delay on reforms can lead to an eternal wait.
If one is entering mid-cap counters in cyclical industries, one needs to understand sector dynamics well. Here, things change over a period of time. Shipping, mining and agro commodities are some examples of cyclicals.
Upward movement typically attracts na?ve investors in these counters. But if one can?t exit scrips at the beginning of a down cycle, he will have to hold on until stocks rise again.
Just a couple of years ago, sugar mid-cap stocks were the darling of the market. However, for those who could not exit at the pick, these counters turned out to be value destroyers. Here, one must note that large businesses turn around fast but the small and mid sized ones take more time.
Portfolio size
Mid-cap and small-cap counters connote higher risks and hence it is important to diversify the portfolio. It has been observed that highly concentrated mid-cap portfolios are susceptible to higher volatility and risks though they have the potential to offer better returns. A good way of investing in mid-sized companies is through a mutual fund.
Holding period
While entering a counter, an investor must have an exit plan. All mid-caps are not great growth stories. There are some value plays in the market and if an investor identifies such stocks, he can encash once the value is unlocked.
Sometimes due to ‘inefficient markets’ an investor may come across good opportunities in the mid-cap space. Here he needs to have a clear picture of the future course.
Do your homework well recognising, if it is a positional trade or an investment. It is not the case that the mid-cap investing is all about long term investing.
Exit
If you are sitting on good money over a long period of time by investing in a mid-cap, it could be time to book profits if you are convinced of a slowdown, especially in cyclicals. Smaller players with distinct skill sets can take advantage of the structural changes in the economy.
Last three years of bull run is nothing but just the trailer and the movie that is yet to begin. As an investor you can make good money if you can keep realigning your mid-cap and small-cap portfolio along with changing times.
