Have mid-caps corrected enough or is it good to stick to large caps?

The chart below captures the performance of the Nifty Index versus the NSE Mid Cap Index since the beginning of 2018. The contrast is quite stark. The Nifty has actually outperformed the Mid Cap Index by almost 20%. In fact, if one were to look at the Nifty on any normal trading day, it would be hard to fathom the extent of damage that has been wrought on mid caps. The fact is that on Monday (16th Jul) alone, more than 200 stocks touched their 52-week lows. In most cases, the mid caps have corrected anywhere between 30% and 70%.

The chart above clearly indicates that mid caps have rally underperformed the large caps since the beginning of the year. Does this make a case for buying mid caps? Let us first try to understand why the mid caps corrected in the first place…
What explains the sharp cuts in the mid cap prices?
Bet 2014 and 2017, the mid caps stocks in the index have consistently outperformed the Nifty stocks by a vast margin. In fact, even during times of heightened volatility between 2014 and 2017, the pressure on mid caps and small caps was not really too much. What explains this sharp correction in mid caps? There were 3 reasons for the mid-cap fall…
Mid-caps had been big beneficiaries of the dividends of cheap oil, especially when the price of Brent crude fell from $115/bbl to $40/bbl. This did a world of good for their cost structures and their operating margins.

The regulator, SEBI, had imposed special margins on a host of mid cap and small cap stocks. These margins were so steep that they literally curbed the speculation on these stocks leading to a sharp sell-off.

Lastly, the capital gains tax introduced by the government in Budget 2018 proved to be dampener for mid-cap stocks. Since March 31st 2018 was the deadline to sell stocks without attracting LTCG tax, many HNI and retail investors did see merit in taking money off the table. That also led to the sharp correction.
But mid-caps still have some merit left in them
Unlike a large cap companies operating in sectors like power, telecom, infrastructure and metals; the mid cap companies are not over-leveraged. Hence the level of financial risk is much lower in these stocks. Secondly, mid caps have consciously stuck to their core competency rather than trying to diversify into unrelated areas. As a result, they have never carried a baggage like a lot of conglomerates in India did. This has helped them manage business uncertainty a lot better. Lastly, most mid caps have corrected sharply in the last few months and that has led to the valuation premium over large caps evaporating in most cases. If you believe that it is mid caps that will become value creating large caps, then this is the place to be in. Here is how you should go about selecting mid caps in your portfolio.
You stand a better chance of creating wealth with mid-caps
It may appear quite brave to say that at this juncture, but that is the reality. Consider these samples. An investment of Rs.10,000 in Wipro in 1980 would be worth Rs.500 crore today. An investment of just Rs.1 lakh in Havells in 1996 would be worth Rs.30 crore today. We can narrate similar stories about Eicher, Escorts, Ajanta Pharma, Symphony, Lupin and Britannia and the list can go on. Suffice to say that mid-caps should still be at least 50% of any retail equity portfolio. Here are the precautions you need to take and checklists to apply…
Focus on past performance. We are talking of a consistent performance over the last 4-5 years. This may not be an assurance of future returns but it is the closest you can get to assurance of good performance. A mid-cap company that consistently delivers on top-line growth, bottom-line growth and margins is surely a good story.

Don’t stuff your equity portfolio with midcaps at random. Be selective about the mid caps you are buying and make it a point to hold them for the long term. Let mid caps be around 25-30% of your overall portfolio. That will keep the focus on alpha rather than on beta. You must really buy a mid cap because it is going to generate genuine alpha.

Ensure that the stock is liquid, frequently traded, has volumes above 10% of market cap and is widely held. You obviously do not want to get stuck in a stock which you cannot exit. Ensure that you can exit the stock at short notice and without too much of an impact cost.

Focus your analysis on risk-adjusted returns. If a stock is generating higher returns by taking on too much of risk, it is not worth the while. Companies like Eicher, TVS Motors became multi-baggers because they created profitable business models without playing ducks and drakes with shareholder money. That is the key.

Check out the stock has performed in downturns. That is a better judge of the quality of the stock than just looking at it in upturns. If the stock has held value better in downturns, then you have a stock to invest in. That is what truly separates the wheat from the chaff when it comes to mid cap stocks.

Quality mid cap and small stocks are few and far between. Hence an in depth understanding is a must before investing in them. Mid caps and small caps are not as well researched as the large caps as these stocks are not favourites of institutions. Do your homework before buying mid cap stocks!
As stocks become larger in market cap, they tend to become languid and size works against them. That is where mid-caps have a role to play. They are a must-have in any portfolio and this correction is your time to take the shopping baskets out and start cherry picking.

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