The Allure of Mid-Caps

As of now, the segment that is leading gains in the equity hemisphere is definitely the broader market with the Mid-Cap index heading it. Among major equity indices it was the first to recover from a drawdown in May 2023 while its larger counterpart took one more month to reclaim its earlier highs. The article explains why mid-caps should be a part of your investment portfolio 

The Indian equity market has been on a roller-coaster ride in the last one and a half years. The Nifty 50 index, which tracks the 50 largest companies listed on the National Stock Exchange, peaked at 18,600 in October 2021, but fell by about 10 per cent over the next couple of quarters. The broader indices saw a much sharper fall and the Nifty Mid-Cap 150 index fell by a little more than 20 per cent in the next eight months. The decline in the equity market has been driven by a number of factors. [EasyDNNnews:PaidContentStart]

First of all, it was definitely the meteoric rise in the index post-pandemic, which had put the valuation at lofty levels. Nonetheless, what also led to such fall was the change in macroeconomic conditions. There was a tightening of the monetary policy by central banks around the world, which is raising borrowing costs and making it more expensive for companies to finance their operations while increasing the cost of equity. What fuelled this further was the conflict between Russia and Ukraine, which has led to higher commodity prices and uncertainty about global growth. 

Nevertheless, most of the worries are behind us now as inflation has moderated everywhere. The central banks are now not sounding so hawkish and the war between Russia and Ukraine is still not over but remains a non-event from the equity market perspective as of now. The result of all this development has put the global equity market on the path of ascent once again with the Indian equity market not being an exception.

The segment that is leading such gains is definitely the broader market with the mid-cap index heading it. Among major equity indices it was the first to recover from a drawdown in May 2023 while its larger counterpart took one more month to reclaim its earlier highs. The graph below shows the performance of Nifty indices since October 2021. It is clearly visible that the Nifty Mid-Cap index has been the first to reclaim its earlier peak. 

Over the past six months, the stocks in the mid-cap segment have shown remarkable performance with two of the Top Gainers delivering multi-bagger returns to investors. REC stands out as a frontrunner, boasting an impressive gain of 115.31 per cent, closely followed by Indiabulls Housing Finance at 102.46 per cent. SJVN and Polycab have also posted substantial gains of 90.22 per cent and 81.05 per cent, respectively. Bharat Heavy Electricals (BHEL) completes the list with a notable gain of 95.14 per cent. It’s worth noting that four out of these five top gainers belong to the infrastructure sector, reflecting the robust capital expenditure plans outlined by the Government of India. 

Conversely, there have been very few losers in the same sixmonth period. Only five out of 150 companies have registered negative returns with the majority delivering positive gains. Among the Top Losers during this period are Adani Total Gas and Rajesh Exports, witnessing declines of 26 per cent and 18 per cent, respectively. 

A detailed analysis of the constituents of the Nifty Mid-Cap 150 index underscores their outstanding performance. These companies have, on an average, achieved a remarkable price increase of 31.63 per cent, indicating consistent growth. Furthermore, their median return of 28.13 per cent reflects their resilience and ability to consistently deliver positive returns. 

Reasons to Invest in Mid-Cap Stocks

1) Superlative Performance- In the realm of broadbased equity indices, the mid-cap index has consistently held a historical reputation for stellar performance. A thorough analysis of data dating back to the inception of 2005 reveals that the Nifty Mid-Cap 150 has consistently delivered the most impressive returns. The following graph vividly illustrates the performance trends of the three major broad-based indices since the beginning of April 2005. 

When measured on an annualised basis, the mid-cap index, as represented by the Nifty Mid-Cap 150, has exhibited a remarkable annual return of 15.76 per cent since 2005. In contrast, the Large-Cap index, embodied by the Nifty 50, has yielded a return of 12.94 per cent over the same period. 

The mid-cap index in India has performed well historically, outperforming both the large-cap and Small-Cap indices over the long term. This is due to a number of factors, including the growth of the Indian economy, the rise of new technologies and the expansion of international markets, all of which has helped the mid-cap companies to grow. Mid-cap companies are typically still in the growth stage of their lifecycle, which means they have the potential to grow their earnings and revenue at a faster rate than large-cap companies. 

2) Diversification Benefit - Another compelling aspect favouring mid-cap stocks is the diversification they bring to the table. By strategically investing in a blend of mid-cap stocks, you can effectively mitigate the overall portfolio risk. This arises from the fact that mid-cap stocks generally exhibit lower correlation with their large-cap counterparts, resulting in a greater degree of independence in their price movements. In our meticulous analysis of returns pertaining to both large-cap and mid-cap indices, we have consistently observed an average correlation of 0.8. It’s noteworthy that this correlation pertains to the index level. If we delve deeper and scrutinise correlations at the company level, they are likely to decline even further. This presents a compelling rationale for investors to incorporate mid-cap companies into their investment portfolios. 

3) Better and Stable Returns - To understand the return character of a portfolio that is equally weighted in terms of both the large-cap and mid-cap stocks and is rebalanced annually, we conducted a study of data over the last 18 years. For this we took the Nifty Mid-Cap and Nifty 50 indices as representatives of mid-cap and large-cap stocks. The table below shows the performance of such a portfolio. 

The data above presents a comprehensive snapshot of portfolio performance alongside the mid-cap and large-cap indices. Over the past three months, the portfolio, constructed with an equal weight allocation between large-cap and mid-cap stocks, has delivered a robust return of 11.70 per cent. During this period, the mid-cap stocks outperformed with a gain of 17.79 per cent while the large-cap stocks posted a comparatively modest increase of 5.13 per cent. This trend has extended over the past six months with the portfolio registering a substantial 21.52 per cent return. 

The mid-cap stocks, displaying remarkable dynamism, surged 31.43 per cent, leaving large-cap stocks behind with an 11.37 per cent gain. Year-to-date, the portfolio has generated a commendable return of 16.44 per cent, once again showcasing the potency of diversification. In comparison, mid-cap stocks soared by 28.67 per cent while the large-cap counterparts posted a more conservative 7.35 per cent uptick. Looking at longer time horizons, the portfolio’s performance remains noteworthy. Over the past three years, the annualised return stands at 24.10 per cent, outpacing large-cap index return (19.23 per cent). 

Similarly, the portfolio’s 10-year annualised return of 15.80 per cent surpasses large-cap index return (13.36 per cent), illustrating the enduring advantages of maintaining a balanced exposure to both the market segments. Some of you may have doubts about the need to construct a portfolio when you can get better returns while investing in mid-cap stocks, which have consistently generated better returns across a wide timeframe. The reason for making a portfolio lies in the distribution of returns. The following histogram shows the return distribution of a portfolio with both large-caps and mid-caps. It clearly shows that the portfolio has generated stable returns when compared to large-cap and mid-cap indices. 

One of the reasons why mid-cap stocks can offer value is because these companies are often undervalued by the market, which means you can potentially buy them at a discount. This can lead to higher returns over the long term. Nonetheless, for the same reason they also get loaded with certain risk. 

Risks Associated with Mid-Caps

Investing in mid-cap stocks does come with its share of risks. First of all, mid-cap stocks are generally more volatile than their large-cap counterparts, implying that their prices can exhibit greater short-term fluctuations. Our analysis further underscores this volatility by revealing that mid-cap stocks have experienced more significant drawdowns. For instance, during the global financial crisis, they plummeted by as much as 73.37 per cent. 

While mid-cap stocks tend to exhibit smaller declines than small-cap stocks, they still tend to experience more substantial drops when compared to large-cap stocks. The higher volatility can lead to larger price fluctuations, which may result in significant gains but also substantial losses. Hence, investors need to have a higher risk tolerance when investing in mid-caps. The graph below illustrates the historical drawdowns of these indices, shedding light on the extent of these fluctuations. Secondly, mid-cap stocks may not be as liquid as large-cap stocks. This means that it may be more difficult to buy or sell them quickly, , if you want to buy in large quantity. And the third factor is that mid-cap companies may be undervalued by the market and there can be a genuine reason for such undervaluation, which means you could potentially lose money if you buy their stocks. Besides, during periods of market enthusiasm, mid-cap stocks might experience a PE expansion, meaning that their PE ratios increase even if their earnings growth isn’t as substantial. 

This can lead to stocks being priced at levels that might not be justified by their fundamental performance. Entering into such a scenario may lead to larger losses. However, despite the risks, mid-cap stocks can be a good investment for investors who are looking for growth potential, diversification benefits and value. However, it is important to do your research and understand the risks associated with investing in mid-cap stocks before you make any investment decisions.

Analysing Mid-Cap Companies

There is nothing different when analysing mid-cap stocks. They can be analysed by evaluating factors such as financial performance, industry trends, competitive positioning and valuation. 

Look at metrics like earnings growth, PE ratio, debt levels and cash flow. Consider the company’s market share, competitive advantages and potential for future growth. Also, stay updated on macroeconomic factors that could impact the mid-cap sector. Conduct thorough research, possibly using fundamental and technical analysis, to make informed investment decisions. For retail investors liquidity might not be an issue, but HNIs or institutional investors need to check liquidity in the stock. 

Right Time to Invest in Mid-Cap Stocks

Mid-cap companies and stocks are often characterised by their high beta in relation to economic growth. They have a tendency to react swiftly to changes in the economic landscape, both surging ahead when times are good and experiencing more significant declines during economic downturns. India’s gross domestic product (GDP) has recently demonstrated remarkable resilience, registering a growth rate of 7.8 per cent in the April-June quarter of 2023 (Q1FY24), surpassing the 6.1 per cent growth recorded in the previous quarter, as reported by the National Statistical Office (NSO). 

This impressive growth can be attributed to several factors, including increased government capital expenditure (capex), a surge in consumption demand and heightened activity within the services’ sector. Following the release of the robust GDP growth figures for the June quarter, leading economic forecasting agencies and international brokerage firms such as Moody’s, Morgan Stanley and Nomura raised their annual growth projections for India. Moody’s, for instance, revised its growth forecast for India in the 2023 calendar year from 5.5 per cent to 6.7 per cent, underlining the nation’s robust underlying economic momentum. 

The Indian manufacturing sector has managed to bolster its profit margins by taking advantage of lower commodity prices, effectively offsetting the impact of successive interest rate hikes since May 2022. This strategic manoeuvre has allowed the Indian economy to maintain its robust growth trajectory even amidst a global economic slowdown. Additionally, the significant growth in India’s services sector, which constitutes more than half of its economic output, has played a pivotal role in helping the nation defy the global economic slowdown that has affected many major economies, including China. 

To sustain and accelerate economic growth, the Indian government has prioritised infrastructure development by front-loading its annual spending. This commitment is exemplified by the rapid utilisation of nearly 28 per cent of the allocated capital expenditure budget of ₹ 10 lakh crore within the initial three months of the fiscal year. These proactive measures reflect India’s dedication to maintaining a flourishing economic environment.

Valuation and Outlook

As of August 31, 2023, the Nifty Mid-Cap 150 index has exhibited returns of 24.24 per cent on a year-to-date (YTD) basis, 24.63 per cent over one year and 16.88 per cent over five years (CAGR). The index’s returns standard deviation is 11.90 and 19.14 for one year and five years, respectively. It has a price-to-earnings (PE) ratio of 25.32x and a price-to-book (PB) value of 3.71x with a dividend yield of 1.06x. The average of PE, PB and dividend yield since the start of 2006 is 30.88x, 2.8x and 1.24 per cent. 

In terms of PE, Nifty Mid-Cap is currently trading above its long term average, however near to its above one standard deviation. Historically speaking, we have seen that once the mid-cap stocks start to perform they tend to shoot beyond two standard deviation of their historical valuation. Hence, with the strong outlook for India’s economy, the mid-cap sector is poised to grow with various sectoral tailwinds on its way. 

Research Methodology: 

To come up with a ranked list of mid-cap stocks, we took into consideration five crucial parameters. The first includes market capitalisation. The remaining parameters are obtained from the Profit & Loss Account and include Sales, Operating Profit and Net Profit. We also considered the PAT margin for ranking the stocks as it indicates how efficient a company has been in converting the given sales into profits. Each parameter was then ranked by awarding it a carefully determined weightage based on its significance. 

We then segregated the companies into three categories as follows: 

◼ Turnaround Performance: Turnaround Performance: These companies include those that successfully managed to turnaround the losses incurred in FY22 into profits in FY23. Download the complete financial data of MID-CAP companies by Scanning this QR code

◼ Improving Financials: Although these companies still reported losses in FY23 as they did in FY22, they succeeded in reducing these losses by a notable amount. This indicates that they are on the road to recovery.

◼ Thriving Companies: This list includes all the remaining profitable mid-cap companies in FY23. 

A consolidated ranking was done in each category to arrive at the list. All the raw financial data is sourced from Ace Equity and price-related information is as of August 11, 2023. 

Download the complete financial data of MID-CAP companies by Scanning this QR code 

[EasyDNNnews:PaidContentEnd] [EasyDNNnews:UnPaidContentStart]

[EasyDNNnews:UnPaidContentEnd]