Mid-Cap: What To Expect Going Ahead

On an average, the Mid-Cap stocks have generated a mean return of 48.56 per cent, showcasing a solid performance in this space. However, the standard deviation is notably high at 56.25 per cent, which shows significant variability in returns across the mid-cap index’s constituents. The article provides insights about the performance of the mid-cap stocks 

Over the past 15 months, mid-cap stocks in India have shown remarkable resilience, seemingly defying market gravity. During this period, the Nifty Mid-Cap index has delivered an impressive return of 91 per cent, experiencing negative returns in only four out of these 15 months. This strong performance persisted despite warnings from institutional investors and regulators urging caution in this segment. Mid-caps have significantly outperformed their Large-Cap counterparts, which have returned 44 per cent over the same timeframe, effectively doubling the returns of the large-cap index.

Mid-cap companies, which fall between ranks 101 and 250 when sorted by market capitalisation, offer investors a compelling mix of stability and growth potential. These companies often have a greater capacity for rapid expansion compared to larger firms while maintaining a lower risk profile than Small-Cap stocks. As a result, mid-caps represent a strategic sweet spot for investors seeking both growth opportunities and relatively stable investments.

Delving deeper into the performance of constituents of the mid-cap index gives a slightly different picture. On an average, the stocks have generated a mean return of 48.56 per cent, showcasing a solid performance in the mid-cap space. However, the standard deviation is notably high at 56.25 per cent, which shows significant variability in returns across the index’s constituents. While the best-performing stock (Oil India) surged by 292.93 per cent, the weakest (Zee Entertainment Enterprises) experienced a decline of 44.7 per cent. A majority of mid-cap stocks have delivered moderate to strong returns, with the median return standing at 35.06 per cent. The following diagram shows the return distribution of constituents of the mid-cap index in the last one year.

Drivers of Mid-Cap Outperformance
Several factors have contributed to the strong showing of mid-cap stocks over the past year. Firstly, the robust recovery in economic activities post-pandemic has significantly boosted the economy, where many mid-cap companies have a strong presence. Secondly, government initiatives, such as the Production-Linked Incentive (PLI) scheme, have provided a substantial push to manufacturing and export-oriented mid-cap companies, helping them expand operations and improve profitability

Additionally, the resurgence of retail investor participation in the stock market has also played a crucial role. Retail investors, attracted by the growth prospects of mid-caps, have increased their exposure to this segment, further driving up prices. Institutional investors, including domestic mutual funds, have also raised their allocations to mid-cap stocks, seeing them as a potential source of alpha generation.

1. Economic Growth as a Catalyst for Mid-Cap Performance India’s economy has been one of the best-performing major economies globally, driven by strong domestic consumption, robust investment flows, and a stable macroeconomic environment. As the economy grows, it creates a favourable environment for mid-cap companies, which are often wellpositioned to capitalise on the expanding market opportunities.

These companies are typically in a growth phase, and a rising economy boosts their revenues and profitability. The thriving economic landscape allows mid-cap firms to expand their operations, invest in new projects, and enhance their market presence. This economic momentum acts as a tailwind, enabling mid-caps to achieve higher growth rates and attract investor interest, thus pushing their stock prices higher.

2. Benign Macroeconomic Conditions Supporting Mid-Caps The current macroeconomic conditions in India are conducive to business growth, especially for mid-cap companies. Interest rates remain relatively stable, making borrowing more affordable for businesses looking to expand. Inflation around the world is showing signs of moderation and this will prompt central banks to cut interest rates. This low-cost capital environment is particularly beneficial for mid-caps, which often need to secure financing for growth initiatives, such as capacity expansion, product development and market diversification.

Additionally, inflation has remained under control, which helps mid-cap companies manage their input costs more effectively. Stable inflation rates also support consumer purchasing power, driving the demand for goods and services offered by mid-cap firms. These benign macroeconomic factors create a fertile ground for mid-caps to thrive, as they can focus on scaling their operations without being overly burdened by high borrowing costs or unpredictable input costs.

3. Market Sentiment and Investor Appetite for Mid-Cap Stocks The strong performance of mid-cap stocks has sparked positive market sentiment, drawing increased attention from both retail and institutional investors. The growth potential of mid-cap companies makes them appealing to investors seeking to enhance their portfolio returns. Additionally, the resurgence of retail investors and the growing popularity of mutual funds have boosted the demand for mid-cap stocks.

Institutional investors, including domestic mutual funds, have also increased their allocations to mid-cap companies, viewing them as a strategic way to generate alpha in a diversified portfolio. This growing investor appetite has provided substantial liquidity support to mid-cap stocks, fuelling their price appreciation and enhancing their overall market performance.

Going Ahead
The strong performance of the mid-cap stocks has led to higher valuation of the mid-cap index. One of the popular gauges of measuring valuation price-to-earnings (PE) ratio has increased from around 23 times at the start of April 2023 to around 44 times currently, almost doubling in the last one year. When compared to last five years of the PE range, it is currently trading above 90 percentiles.

Against the average PE of 28.37 in the last five years, it is currently trading a shade below 45.4, which remains the highest in the last five years. When it comes to price-to-book value (PBV) – another way to look at valuation – it looks stretched. Against the average of 3.91 times, it is currently trading at 5.55 times, not too far from the five-year high of 5.61.

Let’s check with the financials and see how much they justify the heightened valuations. The financial performance of the constituents of the mid-cap index shows significant variability in both sales and profit growth on a yearly (YoY) and quarterly (QoQ) basis. The average sales growth on a YoY basis is relatively modest at 2.26 per cent, indicating subdued top-line growth for the index constituents, while the average sequential growth in sales is stronger at 13.80 per cent, suggesting some positive momentum in recent quarters.

However, the high standard deviations of 22.18 per cent and 17.93 per cent for YoY and QoQ sales growth, respectively, reflect substantial disparities among companies, ranging from a minimum of -77.87 per cent to a maximum of 149.45 per cent on a YoY basis. Profit performance is markedly more volatile, with an average YoY profit growth of 71.44 per cent and a substantial QoQ growth of 35.50 per cent, indicating significant profitability improvements across the board.

However, the exceptionally high standard deviations of 572.28 per cent and 155.12 per cent for YoY and QoQ profit growth, respectively, reveal large disparities. The profit growth ranges from -296 per cent to an astonishing 6,737.80 per cent on a YoY basis, demonstrating that a few constituents may have driven the high average due to extreme profit surges.

Additionally, quarterly profit growth ranges wildly from -1,073.58 per cent to 803.02 per cent, underscoring the index’s exposure to substantial quarterly profit fluctuations. In summary, while the average performance metrics suggest positive growth trends, particularly in profits, the high variability and the presence of extreme outliers indicate that the mid-cap index constituents are experiencing highly uneven performance, with some companies thriving while others face significant challenges.

Conclusion
The broader indices have reached record highs, despite ongoing concerns about valuations, mainly driven by the outperformance of a select few stocks. This trend is reflected in the daily market breadth and the performance of mid-cap stocks, where the overall index performance appears stronger due to exceptional returns from a handful of stocks. For example, while the Nifty Mid-Cap index has returned 50 percent over the past year, the median return of its constituents is only 35 per cent, highlighting a skewed performance distribution.

Our analysis also indicates that only a few companies have financial results that justify their elevated valuations. As a result, we anticipate that this selective participation will continue, which will likely support a positive outlook for the indices, albeit with a more gradual pace of gains. Given this environment, we recommend a selective investment approach, focusing on sectors and themes that are attracting significant interest and offer compelling valuations. Investors should be cautious about increasing exposure to loss-making stocks based on expectations of a rebound.

Instead, they should consider switching within the same sector or to other sectors that provide a margin of safety. According to Bloomberg consensus, analysts project that the EPS for the Nifty Mid-Cap 150 is expected to grow at over 20 per cent for FY24-26, suggesting potential for similar returns or slightly lower returns as we have moved up substantially. Hence, we advise investors to align their fund allocations and investment strategies with long-term goals and risk tolerance, rather than reacting to short-term market movements. While mid-caps have delivered robust returns over the past year and generally outperformed large-caps over the long term, it’s important for investors to set realistic expectations for future returns.

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: These companies include those that successfully managed to turn around the losses incurred in FY23 into profits in FY24.
■ Improving Financials: Although these companies still reported losses in FY24 as they did in FY23, 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 FY24. 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 13, 2024.