The Nifty and Sensex are close to their previous highs. However, the CNX Midcap and BSE Midcap indices are still hovering between 21 per cent and 37 per cent below their previous highs. These stocks provide a good investment opportunity over the next 18-24 months.

Well-run mid-sized companies have historically delivered phenomenal returns over longer time periods. Many such firms are driven by competent and motivated entrepreneurs. They develop cost-efficient structures, brands and distribution franchises growth while maintaining good return ratios.

Mid-cap companies typically trade at a discount to their large-cap counterparts. When a good quality mid-sized company delivers consistent growth, returns from such a company can be two-fold — through normal earnings-led gains and re-rating of valuation multiples.

The figures in the table are based on market close as on January 31, 2014. The stocks and returns are for only illustrative purposes and should not to be construed as investment advice.

Worth exploring now? The discount between mid- and large-cap stocks is currently ruling at 25-30 per cent, higher than the historical averages of 15-20 per cent. Many mid-caps are trading at 9-11 times the forward multiple, compared to the historical averages of 12-13 times. With sentiments improving, these mid-caps have very good odds of bouncing back to historical average valuations and providing superior returns. However, bottom-up stock picking will be of importance. Along with sentiment improvement, on-ground economic recovery, coupled with rates coming down over the next 18-24 months, can provide relief to certain mid-cap companies. During the run-up to the recovery, today’s concerns such as elongated working capital cycle, depressed growth rates and margins can improve and provide bigger upsides to the profitability of mid-cap companies.

Essentials for investing The company’s business and the market structure in which it operates ought to be understood. Good managements with competence and integrity are essential.

Bottom-up stock selection is important even when one is going by the top-down theme. Be it consumption, export or infrastructure, any mid-cap company should be judged on a standalone basis. Investors should lend a careful look at parameters such as margin defence, return ratios, cash generation and capital allocation decisions over a period of time.

Mid-caps should be examined on at least two valuation parameters -- P/E or P/B ratio or EV/EBITDA or DCF valuation. This exercise will help capture the risks exhaustively.

Once an investing decision has been taken, it is about patiently watching the investment grow for years.

Finally what about risk and volatility in mid-caps?

If the stock selection is done properly, the degree of risk reduces notably. Secondly, if one has invested for a long period with conviction, the risk-reward ratio will improve. One can actually use market volatility to add up good quality mid-caps.

Also, spread the risk across a number of mid-cap companies.

(The writer is Fund Manager of Tata Mutual Fund)

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