The Hindu Business Line : Indexing boosts mid- and small-cap stocks

GROUP together a number of stocks, give that group a name and then wait for the stock prices to skyrocket. This happened in January when the BSE launched the Indonext platform and introduced the `S' Group stocks.

It has now happened with BSE's indices tracking mid-cap and small-cap stocks, which were introduced in April .

Since its introduction, the BSE's Mid-Cap Index has outperformed the CNX Midcap 200 (mid-cap index of the NSE). More notably, the small-cap index has had a spectacular take off.

Another trend also appears to have taken hold of the markets. The introduction of these indices may lead to a reduction in the risks associated with mid-cap and small-cap stocks. If this trend persists, then investing in such stocks may see a new and exciting phase.

On the contrary, these trends could merely be a by-product of excess liquidity in the economy over the past couple of years.

If this is true then the low volatility of these stocks may be due to the influx of hot money into mid-cap and small-cap stocks.

This could bring excess volatility in the months ahead. It is better to be cautious before committing fresh money into mid-cap and small-cap stocks. Careful stock selection and constant focus on expected earnings growth vis-à-vis actual earnings growth is needed.

Trends in mid-cap indices: The total market capitalisation of the BSE's mid-cap index, at Rs 2,84,000 crore, is nearly 70 per cent higher than the total market capitalisation of CNX Midcap 200 at about Rs 1,67,000 crore. The BSE's Mid-Cap Index includes stocks such as Colgate Palmolive, Indian Hotels, Reliance Capital, Syndicate Bank and Jindal Steel.

These stocks are not present in the CNX Midcap 200. The BSE's index has performed better than NSE's index. Average daily returns from the BSE index, since April 11, have been nearly 29 per cent higher than the CNX Midcap 200.

The fluctuation in daily returns of BSE's index is also relatively low. This may not be due to the presence of these stocks alone. The free float method used by BSE's Mid-Cap index may also partly explain the lower volatility and higher returns.

Small-cap, the big story: The trend in the case of stocks that are part of BSE's small-cap index featuring 423 stocks is eye catching. Seventy stocks have risen by more than 50 per cent. About 215 stocks have risen by more than 20 per cent.

During this period, BSE's Mid-Cap Index and Sensex have risen by a mere 8 per cent. Stocks that have risen by more than 100 per cent in the past two months include Alstom, Assam Company, Elecon Engineering, Vindhya Telelinks and Ansal Properties. Small-cap stocks look red-hot now.

Indexing and risks: A more notable feature has been the low fluctuation in daily returns of the mid-cap stocks. Since April 11 , fluctuation in daily returns of BSE's Mid-Cap Index has been lower than that of the Sensex.

In terms of beta, a statistical measure of risk, both mid-cap and small-cap indices appear to be less risky than the Sensex.

Given the short time since their introduction, could this be a flash in the pan? Unlikely. This is because, in the period since April 2003, CNX Nifty Junior's risk has been lower than that of Nifty and CNX Midcap 200's risk has been lower than that of Nifty Junior.

These results, which indicate that mid-cap stocks have only been as risky as large-cap stocks, are surprising.

If this is mainly due to their earnings performance — a number of mid-cap stocks have been reporting larger earnings growth and higher return on net worth compared to large-cap stocks — then it could be a harbinger of growth for the constantly evolving Indian economy.

If so, the introduction of these indices will catalyse investing in mid-cap and small-cap stocks. It could be a mere by-product of the huge increase in fund flows into mid-cap and small-cap stocks.

The key is earnings performance and investors can expect the story to unravel over the next few months.

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