The Hindu Business Line : Rich state of mid-cap market

AS INVESTORS strap on for the Sensex's leap towards 10,000, valuations appear stretched, especially in the mid-cap segment, where they seem as stretched as in their large-cap counterparts. For many, this alone is an indicator of a bubble building up in the mid-cap space.

The mid-cap segment, however, is not without its attractive features. There is considerable potential for achieving diversification in the mid-cap space which, alone, provides exposure to some industrial segments.

There is another indisputable fact — as foreign institutional investors enter a mid-cap stock graduating into a large-cap stock, valuations rise sharply. This factor is now being priced into all mid-cap stocks.

State of valuation: BSE-200's price to earnings multiple is now about 18 — on the face of it, hardly anything to be bothered about. This is, however, a statistical mirage. Market-cap weighted PEM for the market is about 27.

In stocks with market capitalisation in excess of Rs 5,000 crore — 85 in number — the PEM is about 27.

For the stocks with market capitalisation of Rs 750-5,000 crore — 280 in number — the PEM is about 30.

A PEM of 30 requires average profit growth in excess of 20 per cent over the next five years. That would require a return on net worth of about 25 per cent to be sustained over a long period of five years or more. That would be an insurmountable hurdle for a number of companies in this universe of mid-cap stocks.

In large-cap stocks, high PEM is not as big a cause for concern. Given their stable, long-term presence in the economy, return expectations will have to be low.

Thus, even with a return on net worth of about 15 per cent, they can deliver after-tax returns of about 8 per cent per annum. That would be considered attractive.

Mid-cap features: The mid-cap segment, however, boasts several attractive features. First, there is immense scope for diversification. It is not only in terms of the number of stocks in the universe but also in terms of industrial segments, to which investors can now gain exposure through mid-cap stocks.

Exposure to a number of industrial segments, such as sugar, ship-manufacturing, watches and jewellery, biotechnology, breweries, organic chemicals, computer hardware, couriers, hospitals, paper, pesticides and textiles is now possible only through mid-cap stocks.

There is another set of rapidly growing industries, such as construction, financial services, retailing and auto ancillaries, in which large-cap stocks provide only a relatively smaller exposure. If you want larger exposure, you have to take positions in the mid-cap space.

The mid-cap space itself is immensely diversified. The top five large-cap stocks account for about 30 per cent of the market-cap of large-cap stocks. The top five mid-cap stocks account for 4.8 per cent of the market-cap of mid-cap stocks. The top five industrial segments account for 69 per cent of the market-cap of large-cap stocks.

In mid-caps, the proportion of the top five industrial segments is 42 per cent. In addition, these industrial segments lend themselves to further segregation. For instance, capital goods account for 8 per cent of the mid-cap stocks and 4.8 per cent in the large-cap space.

In the mid-cap space, capital goods represent engineering, engines, pumps, electronics, pollution control equipment, electric equipment, textile machinery and compressors. In the large-cap sector, capital goods represent electric equipment and electronics predominantly catering to the power sector. This is the case with a number of other sectors too.

It is now possible to build a 100-stock mid-cap portfolio that will offer exposure to 50 different industrial segments. There are only three industrial segments to which mid-cap stocks do not provide adequate coverage. These are telecom services, software and airlines. Otherwise, breadth of offering in the mid-cap category is superior to the large-cap landscape.

FII factor: The FII factor offers the most powerful explanation for the mid-cap craze. As a stock's market cap increases steadily above the billion-dollar mark, the appetite of FIIs appears to be rising. This gave rise to mid-cap arbitrage.

Stock price returns for a mid-cap stock turning into a large-cap were usually substantial. Now, in anticipation of such returns, investors have taken positions in a number of mid-cap stocks.

At least in 2006, valuation of mid-cap stocks will not come down in a hurry. It will keep pace with the valuation of large-cap stocks. The superior valuation of mid-cap stocks over a longer term is, however, dependent on their ability to sustain earnings growth. In large measure, that is wholly dependent on industrial growth.

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