Getting Into Quality Mid Caps Now is Crucial

By Mr. Nemesh Shah, ICICI Prudential Asset Management Co

The recent rise in small- and mid-cap stocks does not come as a big surprise during an economic recovery.

Small- and mid-caps, especially in the value and cyclical space, stand to gain the most as the expansion in the economy tends to offer higher growth potential for these companies. It’s none more evident in the way the major indices have moved up so far. This past one year (1 July 2013 to 30 June 2014), the CNX Midcap index rose 47 % and CNX Smallcap, 80 %, while CNX Nifty moved up by 29 %.

Now the important question in any investor’s mind is whether this is just a one-time rebound, as may be typical of any rising market, or is there more potential for small- and mid-cap companies to outshine? There’s no doubt that there is still plenty of potential still left to be tapped among the mid- and small-companies.

 

Nemesh Shah,
ICICI Prudential AMC

 The economic recovery is only just beginning. The recent industrial production growth numbers have been very encouraging, and point out that better days are ahead. In fact, mid- and small-cap companies continue to be in a sweet spot in the economy as against this time last year, when they were going through a difficult phase as the slowdown took a toll on the economy. During that period, the mid-caps were taking a heavier beating than the large-caps. One can see this taking place in the three years from June 2010 to June 2013. During that period, the CNX Midcap index fell 2.4 % compounded annualized, while the Nifty increased by 3.1 %.

This was despite the fact that the economic environment was the same for both the classes of stocks. While the market can tend to be unforgiving towards smaller companies when things get rough in the short run, the bigger companies may still find themselves on sturdy ground on the strength of their balance sheets and better market positions. Smaller companies face the music when it comes to getting new orders and sustaining their operations. With costs constant, growth trickling, orders slowing and costs rising, margins of smaller companies tend to get squeezed harder, and their stock prices begin to reflect this. It’s a common problem when an economy slows down such as in the past five years.

 

Making room for growth But come recovery time, and mid-sized companies can recover as smartly, if not better, than some of the well-entrenched bigger companies. Again, this has been in the making in the past year even as signs of the economy bottoming out have been evident. When the recovery consolidates, mid- and small-caps are likely to continue to be in a sweet spot. Even a small recovery in the operating business environment tends to boost the profit growth of smaller companies far higher than their larger counterparts. The best way to explain this is with an example.

The cyclical recovery for a small construction company with idle construction equipment is far better when things begin to improve. A small company is already incurring interest and maintenance costs on its idle equipment, but any order inflows that lead to a deployment of these equipment can easily free up the assets and raise cash flows. As the expenses are already accounted for in the books, a large part of cash flow increase is often directly reflected in the rising profits of these companies. While we are in the early stages of a recovery, the pace of economic growth will improve in the coming years and that’s when companies that are in a position to expand their capacities will tend to do better than the rest of the markets.

This places mid- and small-cap companies in an enviably better position that of growing at above-average rates than their peers. For now, the economy seems to be in an early stage of recovery. The real big growth in mid-caps may be possible and more likely to come when the investment cycle picks up and spending, especially in the core economy, begins to improve. That’s when there should be a bigger tilt of a portfolio towards mid- and small-cap stocks. Building the right portfolio This, however, does not mean that all small- and mid-cap stocks will tend to perform in this market now. A detailed analysis, careful scrutiny and meticulous selection is required. As it happens always, the first leg of the market usually sees all boats rise when the tide is rising, and a lot of stocks go up quite fast. But in the second leg, after the initial rise, the market begins to consolidate.

During these times, one can differentiate the men from the boys. Picking the better-placed mid-caps is key. Companies that are well-entrenched in their businesses and that offer a better potential for growth have to be identified, selected and, more importantly, monitored on a regular basis. Therefore, allocating to mid-caps is one part. It’s essential to watch volatility and aim to reduce it with the right mix. In a market correction, mid-sized stocks can get beaten a lot more than larger companies.

Volatility is common in these stocks, therefore, one has to carefully pick those companies that have less volatility, but do well in a rising economy. This will be the hallmark of a well-rounded portfolio. Mid-caps may be going through a turning point in their trajectory, but one still has to build a portfolio of the right stocks. Buying mid-caps at the right price is even more crucial now, given that many stocks have risen considerably.

For investors, picking mid-cap stocks could be daunting; mutual funds are better placed to do so. Hence, selecting a good mutual fund, which is buying the right mid-caps, is an ideal option for investors who do not want to, or cannot, make the selection themselves.

About the author..

Mr. Nimesh Shah, Managing Director and chief executive officer, ICICI Prudential Asset Management Co

Share: