If the strategy of buying low and selling high is a sure-fire way to make money in the stock market, do mid-caps make a good investment bet now? After all, they have underperformed the large-caps over the last five years, returning little over 5 per cent, against 11 per cent returned by the Sensex on an annual basis.

Even in the year gone by, the BSE Midcap returned flat while the Sensex registered 11 per cent growth. For the most part, mid-cap underperformance was driven by concerns regarding rising input cost inflation, lower pricing power and increasing borrowing costs.

While these concerns still remain, mid-cap valuations have corrected, significantly in some cases, to account for this.

Room for growth…

Over a five-year period the valuation gap between large-caps and mid-caps has widened significantly.

While Sensex saw its PE multiple collapse from 21 times to 20 between May 2006 and now, that of BSE Midcap fell more, from 24 to 17 times. Even on a three-year basis, mid-caps have been underperformers. This, however, isn't the first instance of mid-cap underperformance; mid-caps had fallen more than the Sensex even in October 2005, May 2006 as well as during the extended equity slide in 2008.

While the dips in 2005 and 2006 were short-lived, the drop in 2008 was driven largely by the global credit crisis.

But after taking a severe hit during the credit crisis of 2008, mid-cap earnings have begun to chart a recovery in recent quarters. For one, mid-cap companies have seen a strong acceleration in sales, a sign of healthy demand in recent quarters.

This wasn't the case in 2008, when sales had declined. For the quarter ended March 2011, mid-cap companies (as represented by BSE Midcap) registered 20 per cent sales growth over the corresponding quarter in 2010 (17 per cent in Mar-10).

This is also higher than the 16 per cent sales growth registered in the December 2010 quarter (8 per cent in December 2009).

Profits of companies making up the BSE Midcap index rose 3.3 per cent on a year-on-year basis in September 2010, against a marginal year-on-year decline in profits seen in the June 2010 quarter. The y-o-y profit growth accelerated to 15 per cent in the December 2010 quarter.

While the profit growth has dipped in the March quarter, what investors need to note is the divergence within the mid-cap universe.

Of the 156 index mid-caps that have announced their results so far (which make up the index), 47 posted a 15 per cent plus y-o-y profit growth in the past three quarters. Companies such as Allcargo Global, Info Edge, Sadbhav Engineering and Jubilant Foodworks are some instances.

Large-caps, on the contrary, have seen a dip in both sales and profit growth. Sensex companies registered a 24 per cent and 7 per cent y-o-y growth in sales and profits in the March 2011 quarter as against 34 per cent and 14 per cent y-o-y sales and profit growth registered in the year ago quarter.

…but not without challenges

The key concerns that have battered the valuations for mid-cap stocks are higher input cost inflation and borrowing costs. Though major commodity prices have corrected sharply from their peaks in February, they still remain above comfort levels and, therefore, could eat into margins.

Preliminary signs of margin pressure were evident in the fourth quarter numbers of a few companies. Mid-cap companies, owing to their smaller scale of operations, may not be as well-placed as their large-cap peers to drive a hard bargain with suppliers to manage surging input costs. But here, again, not all mid-sized companies struggle with margin pressures.

Select companies from sectors such as natural gas, pharma and consumers, bolstered by good demand and pricing power, may be in a position to cushion margins.

Adopt a selective strategy

So how should you go about selecting mid-caps for your portfolio? Well, discretion is the key here.

Follow the leader : Look for companies and sectors that are leaders in their segment. Take textile retailer Shoppers Stop, which straddles the premium and mass-market segments. While the company did face margin pressure following the increase in prices of cotton and synthetics, its strong position in the segment afforded it the flexibility to effect price hikes.

The company effected a price hike of approximately 10 per cent in the March 2011 quarter and plans further price hikes in the coming months, which may help increase margins. Leaders in niche sectors, such as Kaveri Seeds and Elecon Engineering also are strong candidates in this regard.

Companies in the consumer non-discretionary space also seem a good choice. Marico, a constituent of the BSE Midcap Index, is an example. It effected a 14 per cent price increase to cushion its margins, but still grew its March 2011 quarter volumes by 10 per cent. While margin pressures cannot be wished away, the key is to look for companies that may enjoy good demand and may, therefore, be able to pass on input costs by way of price hikes to clients. Gold retailers (for instance, Titan) and select consumer durable makers (such as TTK Prestige) also fit the bill.

Less input cost pressure

Companies that have tied up raw material supplies or are backward integrated make a good bet. Carborundum Universal is a case in point. Market leader in the abrasives segment, the company has, by way of acquisitions, locked in access to key and scarce raw materials — such as silicon carbide and zirconia — used in high-end abrasives and ceramics.

Another example here is that of Lanco Infratech, whose acquisition of Griffin coal assets has reduced the fuel risks for its upcoming projects.

Companies that are relatively shielded from rising commodity prices too make a good investment bet in these times. Mid-caps in the IT space make a good choice (for example, NIIT Tech, which has a healthy geographic mix and is beginning to see pricing stabilise and volumes revive).

Low on debt

Given that the rising interest rate regime threatens to pressure mid-caps' ability to borrow, mid-caps that don't have much debt and have fat cash coffers would be better placed. Agri-inputs and chemical companies (such as Kaveri Seeds and Coromandel International) and FMCG companies (such GSK Consumer) with low debt, reasonable demand and pricing power are cases in point.

Companies in the natural gas space too would be relatively less affected by rise in interest rates as they can pass on their costs to the end users. Gujarat State Petronet and Indraprastha Gas (low on debt) are examples here.

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