By Invitation. Should you buy mid-caps now?

Consider this. The stock price of an innerwear company went up 46 times in eight years — from March ’07 to March ’15 at a compounded annual growth rate of 62 per cent. This stock price appreciation has come on the back of sales and profit going up over 11 times. However, the number of pieces sold went up only five times. The rest of the appreciation came from market acknowledging the performance of the company year after year and re-rating its valuations. On trailing EV/EBITDA basis, the stock, which used to trade at 11 times in 2007, is trading at 48 times in 2015.

Simply put, earnings and re-rating going up 11 times and over four times, respectively, led to a 46 times increase in stock price over eight years. This is probably the best wealth creator for its investors. Identifying possible increase in earnings followed by re-rating by markets is the holy grail of investing — particularly small and mid-cap investing.

The advantage of investing in mid-caps is multi-fold. One, irrespective of economic and market conditions, there would be some segments in the economy that could be growing at a higher pace compared to the economy and the market. Two, the companies in these segments are usually under-researched. Hence, information on the segments becomes very critical to evaluate growth prospects.

Three, due to the niche and nascent nature of the segments, ownership of these companies is low. Four, due to the above two factors, there is mis-pricing in the stock prices, which creates an opportunity to purchase.

 How have mid-caps fared? In terms of performance, mid-caps (as depicted by the CNX Midcap index) have done well over large-caps (as depicted by CNX Nifty index) in up market conditions.

In the bull market of 2003-08, mid-caps have outperformed large-caps by 314 per cent. In the down market conditions, they have underperformed in three of the four instances to the extent of 6-10 per cent.

 How should one participate in the action? It is better investors participate in mid-caps through mutual funds. Fund managers have the required experience and resources to identify the segments in the economy and the companies in these segments that can grow faster than the economy. The fund manager is in a position to value the company and the price one can pay for the stock to own it. As he holds a portfolio of stocks, the company-specific risk is minimised. In case that particular segment or company faces head winds, he is in a better position to analyse and exit the stock, if required. 

Is it a good time to invest? Our economy is at the beginning of a sustainable recovery. During the slowdown, mid-cap companies have seen their balance sheets stressed and business models tested. Yet there are many who have come out strongly with increased market share and strong management capabilities of managing growth. These companies would benefit from increased demand, lower input costs and lower interest costs.

Though this is partly captured in the price due to re-rating, there is more to go as earnings return to normal.  Are they expensive? Since September 2013, the time when the recent equity market rally begun, the mid-cap index has gone up 102 per cent while the large-cap index went up 51 per cent. The mid-cap index was at a 19 per cent discount to the large-cap index in terms of price to earnings ratio in September 2013. In contrast, it is now trading at a 17 per cent premium. From a risk-reward perspective, the short to medium-term performance of mid-caps could be challenging. However, the long-term performance could be better.   

 There is a place for mid-caps in one’s portfolio but that should be based on one’s risk profile and asset allocation needs. With this in mind, ride the wave as the adolescents grow into adults, creating wealth for you.

The writer is Co-Chief Investment Officer, Birla Sun Life Asset Management Company

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