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Understand the risk associated with mid-cap stocks

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Mid-cap stocks suffered a setback in the year that went by; stretched valuations and rising oil prices have had a negative impact on earnings growth, forcing investors to move away from mid- and small-cap companies to large-cap corporates.

This, in turn, has led to the Nifty mid-cap index falling 17% in 2018, with a high one-year forward price-to-earnings (PE) multiple quoting at almost 20 times and the five-year average at a little over 35 times [the higher the PE, the higher the valuation of the stock]. On the other hand, the NSE Nifty 50 Index rose over 3% during the same time.

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All of these leaves one wondering: is it advisable to invest in such stocks? How risky will it be at this point?

Understanding mid-caps

Before we delve into the risks involved, let us understand the concept of mid-cap stocks and mid-cap funds. First, the market cap range: mid-cap companies generally have a market capitalisation of between Rs 500 crore and Rs 10,000 crore, and fall between large-cap stocks (Rs 10,000 crore or more) and small-cap stocks (below Rs 500 crore).

Mid-cap funds are those that specialise in investing in such stocks. They rank between the two on key parameters such as size, revenue, staff strength, and client base.

Next, the risks: even as investment options, mid-cap stocks fall between the other two: they are deemed riskier than large-caps but safer than small-caps, especially because the companies are small. However, it is precisely because of this size that mid-cap stocks are looked upon as long-term investment options, with a possibility of becoming lucrative in 3-5 years.

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Having said that, the fact remains that one can never say with certainty that mid-caps will outdo large-caps over the long term (just as one cannot be sure of all large-cap stocks either); what is important is whether the valuations support the stock in question.

Mutual funds that invest in these stocks, called midcap mutual funds, obviously are vulnerable to the same risks. And while they are known to have outperformed large-cap funds in a bull market, they also take a beating during bear cycles; this is because they experience much higher volatility than large caps. For instance, most large-cap companies regrouped after the prolonged bear phase of 2008-2013, but many small- and mid-cap companies did not.

Related: 5 Mistakes to avoid while investing in a bull market

The crisis of 2018

The year started off badly for small- and mid-cap investors, with a large number of stocks in the BSE Mid-Cap index falling by as much as 36% during February-May; in this phase, many stocks on the small-cap index declined by as much as 70%.

In a report, Kotak Securities attributed this to a number of factors other than the usual bear-cycle trend: overheated stocks, mutual fund reclassification, weakening rupee, and crude price volatility. Let us examine the factors identified by Kotak that affected small- and mid-cap stocks in the early months of 2018:

  • An extended rally in 2017 led to overheating of most mid-cap stocks, which showed a high trailing PE ratio of almost 30 times. (Trailing PE is calculated by taking the current stock price and dividing it by the trailing earnings per share [EPS] for the past 12 months).
  • In October 2017, SEBI reclassified mutual funds to bring simplicity, standardisation, and truth in the labelling of the various schemes; this led to fund houses adjusting their portfolios by selling off small- and mid-cap stocks they were invested in.
  • The rupee weakened against the dollar on fears that the interest rates on the US currency would rise, which hit returns (in dollar terms) for NRIs and foreign investors, who dumped Indian stocks worth some Rs 9000 crore in April and May.
  • Crude oil prices rose since the onset of the year, affecting actual disposable income available with households and thereby limiting their investments. This contributed to making small- and mid-cap stocks less attractive.
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Recent trends

However, there are stocks among this lot that have done well despite the factors weighing them down and went on to create wealth for shareholders. Speaking at the Reuters Global Investment Outlook Summit, Manish Gunwani, CIO for equity investments at Reliance Mutual Fund, said stocks in five sectors (cement, power utilities, real estate, hotels and hospitals) are attractively priced ‘after correcting 20-40%’ over the past year.

Gunwani also said that mid-cap stocks had a ‘material upside’ as the adverse effects of demonetisation and GST rollout were ebbing even as the economy grew, and that he would up his exposure to the five sectors in 2019.

There are others too who are betting on mid-caps, including brokerage houses and financial advisors such as Nirmal Bang, Edelweiss, and Karvy. Let us now look at the stocks these two have been backing in 2018 with a long-term view.

Nirmal Bang’s mid-cap picks:

  • S Chand & Co: A leading name in publishing and education services, the company is expected to grow as this evergreen industry grows; as if in vindication of this belief, the company posted its highest growth in the last five years.
  • Shemaroo Entertainment Ltd: This media and entertainment company has seen profits growing at a steady clip of 24% over the past five years, despite incurring a high capex on account of buying the film titles. However, its FY18 closing inventory is a positive sign; it was lower than that of FY17, meaning the investment phase is reaching its end.
  • DCB Bank Ltd: Armed with adequate capital and beefed up by a healthy balance sheet, an added advantage for DCB Bank is its stable asset quality. Its PAT is growing, while a healthy growth in net interest income is expected.
Karvy’s mid-cap picks:

  • Apar Industries: An electrical equipment manufacturer, increasing energy demand, and a revival of the power sector due to the UDAY scheme, are all set to propel Apar, which is already on a growth trajectory. Its reduced debt can only help matters.
  • Greaves Cotton Ltd: An engineering company manufacturing engines and heavy equipment, Greaves is virtually debt-free with good upside potential.
  • Jain Irrigation Systems Ltd: A manufacturer of farming accessories such as drip and sprinkler irrigation and plastic piping and related products, Jain Irrigation is also into food processing, a vertical that has grown in terms of profitability. It also has a healthy domestic and exports order book, which promises a double-digit growth.
  • KPR Mill Ltd: Makers of yarn, knitted fabric, and ready-made garments, the company stands to gain from the government’s increasing focus on the textile sector.
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Last words

Brokerage house Edelweiss feels Lok Sabha polls 2019 should not be a cause for worry. In a report titled ‘India Strategy 2019’, it says the impact of different governments on the market has been diminishing over the years, meaning investors should be on the lookout for opportunities. Edelweiss advises prospective investors to ‘…run a relatively defensive portfolio (large-cap: banks, consumer staples, IT, pharmaceuticals) while keeping an eye open for opportunities that expectations swings might throw up.’

Edelweiss feels the market could run around in circles over the next year, so investors would do well to focus on specific stocks or sectors. The sectors it identifies are IT, rural, industrial and private banks, while 14 stocks seem to show promise; of these, seven are midcap picks: AIA Engineering, Cochin Shipyard, Dr Lal PathLabs, Equitas, Gujarat Gas, Quess Corp, and SIS.



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