This is not a new phenomenon in the Indian equity markets, when the overall sentiment is down, the mid-cap and small-cap stocks lay low and under perform the larger ones. And, when the overall market sentiment improves, these stocks provide handsome returns.

A similar activity is being seen at the moment. When the markets were down, the CNX Mid-cap Index lagged the large-cap indices by 9% between January and March 2009. And then, between April and December it outperformed the large-cap stocks by 39%. Overall, in 2009, the CNX Mid-cap Index was up 99% in 2009, recording second-best year since 2001.

Even in the current year, the mid-cap index has outperformed the benchmark indices. And, in the first fortnight of 2010, some of the firms such as KGN Industries, Bombay Dyeing, and the government-owned Engineers India have recorded gains in the range of 30-49%.

Motilal Oswal Securities MD Ramdeo Agarwal told FE, ?After a long time, we are seeing excitement back in mid-and small-cap stocks.? He believes that since large-cap stocks are looking expensive after last years record rally, there is some selling coming up and the interest is shifting towards mid-cap counters. Agarwal and his team feel that the activity in the mid-cap counters will really pick up from here.

Industry experts observe that a large chunk of the huge inflow from overseas investors is flowing into the mid- and small-cap areas. FII inflow this year, which is 15 days, has already crossed $1.8 billion of which most have moved towards the mid-cap and small-cap stocks. FIIs have been picking up heavy stakes in mid- and small-cap stocks like Amtek Auto, Sundaram Multi, Adhunik Metals and KS Oils, through bulk deals in the market.

One of the prime reasons for this movement was the huge valuation gap that was seen. The large-cap stocks, say in the Sensex, and between the mid-cap stocks and the small-cap stocks.

The Sensex price to earnings was at 80% premium, essentially, more than the BSE-Mid-cap Index in March 2009 and this is shrinking fast. In fact, since November 2009, the premium has more than halved from 13% to 6% on the latest numbers.

So would it mean that the mid-cap stocks have reached peak value? No, say analysts categorically.

According to a survey conducted by CLSA Asia Pacific, 48 stocks in the CNX Mid-cap Index have an optimism ratio of more than one versus only nine out of 30 stocks in the Sensex and 12 out of 50 in the Nifty. The optimism ratio indicates the areas where analysts have a stronger optimism. When the ratio is above one, it indicates that there are more investment professionals who are optimistic than otherwise. The ratio is calculated by taking the number of buy ratings and dividing it by a result of the number of sell recommendations that are subtracted from the number of hold recommendations. Incidentally, the stock optimism ratio is high in sectors like banks and financial institutions, say analysts at CLSA.

Almondz Global Securities Ltd country head (institutional equity broking) Harijith Sing Sethi believes that despite the gap between the valuations of large-cap stocks and small-and mid-cap stocks is now getting bridged, there is a deep value available in mid-cap counters. ?We are seeing increased interest amongst the investing community,? he adds.

And this is because the estimated earnings growth in the mid-cap sector, as the GDP grows and the credit situation improves, is expected to be more than that of the large-caps. The forward looking price to earnings (for financial year for the large-caps is at 16 times whereas that of the mid-caps is 12 times) indicates a premium of 33%. So, mid-caps could well continue to see a sustained positive movement.

Sifting though the chaff

Trade denizen regard mid-cap stocks as those with a market capitalisation between Rs 5,000 to Rs 15,000 crore. The real problem for investors in mid-caps is that there is a wide variety to choose from. Hence, sifting of stock picking is a critical element here and most recommend a bottom-up approach where companies are isolated on the basis of their strong earnings growth juxtaposed with the attractiveness of the sector that they are in, and added with the management’s ability to provide strong corporate governance and an investor friendly attitude.

Analysts at Edelweiss Securities feel that the growing GDP would throw up several opportunities. The current 11.2% rise in the index of industrial production will also spur investors to take positions in the mid-cap sector. They believe that three themes should be looked at while taking investment decisions. This would enable for some sound sifting.

The themes revolve around, the capacity expansion recovery. The reasoning is that there is around $174 billion, or nearly Rs 8,35,200 crore, worth capacity expansion across various industries in the next few years. Companies in the mid-cap sector who are geared to meet this capacity expansion are the ones to look out for.

With increasing liquidity and availability of funds, companies that were severely hit and working capital-intensive companies or companies with highly stretched balance sheets, targeted at expansion are now likely to stage a comeback, reckon analysts at Edelweiss. Top on the list are Aurobindo Pharma, Koutons Retail, TRF, Techno Electric. The theme being companies that had high financial leverage could see the tension easing.

The third theme revolves around operational leverage, or the ability of companies to grow revenues from higher volume growth while keeping costs in control. Here, Edelweiss looks at Usha Martin, Infotech Enterprises, BGR Energy, Anant Raj Industries, and Mahindra Holidays & Resorts, to be some strong prospects.

However, each of these themes comes with equivalent risks. The major risk is the market risk, when markets tank, mid-caps fall faster. The instances are narrowing down as days where the Sensex has fallen and the small sector indices have risen are increasing. Re-working the mid-cap stocks in your portfolio could be a savvy move.