Neelesh Surana, Chief Investment Officer-Equities, Mirae Asset AMC, on the distinctive investment strategies that apply to picking stocks in the mid-cap and small-cap segments. Excerpts:

How do you go about picking the right stocks in the mid-cap space?

Compared to large-caps, mid-caps are relatively less researched, and we have to be careful while handling public money. On-the-ground research is important before deciding to invest in mid- and small-sized companies.

Having said that, irrespective of size, aspects of the stock selection process remain the same. It includes selecting companies in a sector, management analysis and valuation. We look for companies in quality businesses with decent growth prospects as well as good return on capital employed.

The second filter is with respect to management analysis, which is a bit subjective, but you have to look at the track record. Qualitative evaluation of the management in terms of thought leadership and governance is also an important factor to evaluate the prospect of a company.

The last factor is to arrive at a particular valuation for the company. For mid-cap stocks, the value has to be more than the market price so that there is enough 'margin of safety'. Overall, the approach is to buy quality growing businesses that have the potential to scale up, at an early stage.

Given the recent run-up in valuations and the fact that there seem to be only tepid signs of a revival in business prospects, is there a bubble building up in mid-cap stocks?

I do not believe that there is a board-based bubble building in mid-caps, though valuation excesses do exist in select sectors. However, the mid-cap space is large and growing, with more than 400 companies. Despite the run-up in valuations, there are enough opportunities to build a profitable portfolio of select stocks.

If returns from the mid-cap space are not going to be as attractive, is it time for investors to cut their exposure to mid- and small-cap funds?

We always advocate that the allocation to multi-caps should be sizeable and mid-caps should be relatively less. My suggestion is that investors should limit their exposure to 20-30 per cent of their overall investment in equity. Despite the high volatility, I think investors can still maintain the same limit of exposure to mid- and small-cap schemes. It is not a time for rejigging of portfolios —either to increase exposure or to reduce their allocation to this sector.

Going forward, it is important for investors to temper their expectations; they should not extrapolate from the high returns delivered for the past three to five years. They should understand that the high returns in the past were derived from a lower base.

The government has implemented major economic and financial reforms. Which among them do you think will help SME companies the most?

These are still early days to gauge the impact of government policies as they have been rolled out only recently. We need to track the sector for a considerable length of time to take a call on the policy impact. Most government policies will have a bearing across businesses, and will not be restricted to mid-caps.

I think GST is one of the more significant reforms that will help the organised sector compete with relatively less-complaint unorganised players. Many businesses in India have a large share of the unorganised sector represented in their space. Hence many listed companies, which are leaders in their sector, are still treated as mid-caps. For instance, there are large listed companies in sectors such as tiles, plywood, footwear, luggage and apparels, but they are still treated as mid-caps. GST will bridge the gap between tax-compliant companies and relatively less tax-compliant unorganised players.

Given the current valuations, do you still see a value play in SME stocks? Is there a possibility of a sharp correction in mid-cap stocks?

It is difficult to predict near-term movements of markets and it is hazardous to guess the long-term trend. However, some of the areas that look interesting are financials, consumer discretionary, global cyclicals, gas utilities and healthcare. There are enough opportunities for investment as the spectrum of the small- and mid-cap space is broad. There is enough room to make decent return in mid-caps. However, the time-frame should be long term and the returns expectation should be reasonable.

If investors want try their luck in SME stocks, what are your suggestions in resepct of value picks?

While the market offers decent value opportunities for long-term investors, it is always more risky for individual investors to invest on their own in SME companies. Some things are best left to experts to handle. Like I said earlier, it needs a lot of research to select the right SME companies that will deliver the right return. Individual investors will not have enough time and energy to do a thorough research on companies before deciding on their investment in a particular small-sized company.