Time to buy large caps

Mid-cap stocks have been the flavour of the season. Be it mid-cap stocks or mutual funds with a mid-cap focus, they have emphatically outperformed large-caps in the stock market. The BSE mid-cap index rose 20 per cent from January this year, while the BSE 100 delivered 13 per cent.

The difference is even starker at the stock level. While power utility play CESC rallied 39 per cent year to date, large-cap peer NTPC fell 3.5 per cent.

But the rally also meant that valuation multiples for mid-cap stocks are more stretched than before. The BSE Midcap index, for instance, is at a price-earnings ratio of 18 times (source BSE), while both the Sensex and the more diversified BSE 100 are trading at 16.6 times the earnings of their constituents.

But you should not ignore the blue-chips for the following reasons. One, interest rates, though they have begun to decline, may not fall sharply anytime soon. It is mid-cap companies that benefit the most from lower interest rates. Two, large companies have the ability to hold on to their pricing better than midsized ones. Three, larger companies can keep their balance sheet in better shape during crises.

Here’s why mid-cap stocks rallied in recent times and how the almost neglected large-cap ones actually look to be superior investment bets at this juncture.

Why mid-caps ran

The top stock in the BSE Midcap index (3M India) more than trebled in value in the last six months. The best return in the BSE 100 that comprises the top 100 companies was 65 per cent.

Mid-cap stocks generally rise fast in anticipation of higher profit growth during a revival. This time around too, markets did anticipate that an interest rate fall will improve the bottom line of mid-cap companies.

Just to provide an idea on how interest costs eat into profits we ran the 2011-12 numbers of the BSE midcap and BSE 100 companies. Consolidated numbers were taken wherever applicable.

The numbers suggest that BSE Midcap companies used up a good 44 per cent of their operating profits in servicing their interest obligations while BSE 100 companies used up a mere 16 per cent. For close to a third of the mid-cap companies, operating profits covered interest costs by less than two times. Videocon Industries, Dish TV and Jindal Stainless are examples.

Hence a fall in interest rates was expected to benefit mid-cap companies more. But persisting inflation, vitiated by the falling rupee against the dollar have stymied further policy action on interest rates. The RBI’s pause in rate cuts in its recent review also suggests that such an event may not happen any time soon.

Besides, interest rates are not the only issue that mid-sized companies face today.

With limited bargaining power and a necessity to retain clients, mid-sized companies are often forced to provide leeway to their clients to pay their dues, leading to stretched working capital.

Mid-sized construction companies, power transformer and transmission equipment makers are all such examples. This typically forces companies to borrow more for working capital.

But the same is not true of a larger infrastructure player such as Larsen & Toubro or steel major SAIL. With either large clients or the ability to negotiate superior payment terms, these companies seldom face shortage of cash for working capital.

An interest cost increase of over 10 per cent from hereon, without any growth in operating profits, can actually bring down the interest cover ratio to less than two for the BSE Midcap universe. Despite comfortable debt equity ratio of 0.8 times, mid-cap companies’ ability to service their debt may prevent them from leveraging further. This may also hurt growth.

Sales and profits

Besides interest rate risk, mid-caps also appear on a relatively weak wicket compared with the large caps on certain fundamental metrics as well.

Much to their credit, sales for FY-12 expanded 24 per cent for the BSE Midcap companies. This number was 27 per cent for the BSE 100 universe.

While this may per se mean that mid-cap companies have done well, a few issues are worth taking note of. One, the mid-sized companies have managed this growth on a much smaller base.

Two, in sectors where pricing power was firm, larger companies appear to have enjoyed better realisations. They managed to expand their operating profit margins more than mid-sized companies. Large-cap cement play, UltraTech Cement versus mid-sized Shree Cement or Prism Cement is an example.

In sectors where companies did not significantly manage expansion in operating margins, the ability of larger players to retain their margins appeared to be higher. In FMCG, for instance, large and diversified play Hindustan Unilever managed to expand its OPMs marginally in FY-12, while Marico actually saw a dip.

In the capital goods space, players such as BHEL often stayed clear of projects that required them to compromise too much on margins. A mid-sized player such as BGR Energy Systems may not have had that choice at a time when order flows slowed.

One other interesting aspect that seemingly supported mid-cap companies was the raw material cost. For the first time in three years, raw material cost of manufacturing companies as a percentage of sales in BSE 100 was as much their mid-sized counterparts. But this was on account of the high import bill of the large oil refiners, worsened by the rupee depreciation.

Removing these companies in both the sets of data, raw material costs to sales for the large players was 36 per cent as against 42.5 per cent for the mid-sized ones. This comes at a time of higher coal, steel as well as iron ore prices in India due to local factors.

Assuming that India’s raw material prices too, will soon catch up with the global softening trend, big players, which procure in bulk and often on well-negotiated pricing terms, may benefit more from the dip.

Reasonable pricing power, moderate interest costs and ability to pass on raw material cost hikes have helped large-cap companies expand their bottom line albeit marginally. Net profits in FY-12 expanded by 3.4 per cent for the biggies as against the 7 per cent fall seen by midcaps. How’s that for protection in a downturn?

READ ALSO: Quality midcaps not cheap

vidya@thehindu.co.in

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