Midcaps were out of favour in 2018 so far. Is it going to be for rest of the year?

Have mid caps bottomed out; is the standard question that most investors want to know. The answer is slightly more nuanced than the straight forward discrete answer that you will normally expect. Mid caps are going through a churn at four levels. Firstly, the dividends of cheap oil are no longer there for the asking and that is impacting the value of these mid cap stocks in a big way. Secondly, as we saw in the case of stocks like Manpasand, PC Jewellers and Infibeam; these stocks are the most vulnerable to any question markets has pertaining to corporate governance, disclosure standards and transparency. Thirdly, the weak rupee and higher yields are hitting these mid caps where it hurts them the most; and that is on their margins and their financial solvency. Lastly, these mid caps are also taking a big hit on the valuation front despite the sharp correction; many of these stocks are still quoting at fancy valuations. So what do you do? Do you jump in and lap up the reasonably priced mid caps? Or, do you wait and stick to the better honed large caps till there is greater clarity?

Why are mid caps so sharply down?

Mid-caps have corrected sharply since the beginning of calendar year 2018. To an extent, higher oil prices are being cited as one of the reasons for the mid cap crash, the fall in commodities is also a key factor. There were some regulatory and compliance issues like the introduction of additional special surveillance (ASM) margins, which has hit mid cap stocks quite badly. The Union Budget announcement to impose capital gains on LTCG also led to a rush to book profits ahead of the 31st March deadline. In a smaller way, the mutual fund categorization also forced many funds to sell mid caps as valuations were stretched at that point of time. Remember one more thing; the mid cap index does not really represent a heterogeneous group quite well. In reality most mid caps have seen corrections to the tune of 40-70% in the last 7 months. In some extreme cases, it is even as high as 90%.

How to craft your mid cap strategy at this point of time?

Quite often, we hear two extreme views in the market regarding mid caps. You are either advised to splurge on mid caps or to stay off mid caps for the time being. The truth, as is the case most of the times, lies in moderation or the middle path. Your mid cap strategy should be essentially predicated on your capability to separate the wheat from the chaff? While mid caps will continue to be intrinsically risky, the current lower valuations give a level of comfort. Here is a strategy term sheet for you to follow with respect to mid caps…

  • You need to be cautious of the stocks that have been falling vertically and are beset with larger problems of corporate governance. Infibeam, Manpasand, IL&FS, DHFL; obviously have larger inherent problems. Remember, there is no smoke without fire and there is a fire somewhere in these stocks. Having said that; mid caps still hold the potential to become the large caps of the future.
  • Segregate the mid caps that have held value in bad times. When the entire mid cap space has corrected nearly 30%, there must be stocks that have corrected just about 8-10%. Find the story behind this strength and always stick to strong mid caps in these kinds of markets. These are the stocks that will shoot up once the markets reverse.
  • Mid caps, large caps or small caps; profitability and margins can rarely be wrong. When combined with scale, you have a winning recipe for a long term wealth creator. It is mid caps like Lupin, Britannia and Havells that became multi-baggers in the last 10 years.
  • Forget about markets, levels and valuations; companies that are low on debt and on equity will survive and also thrive. Too much debt reduces your solvency and too much equity dilutes your earnings per share and ROE. Prefer lean and mean mid caps that work on cash flows rather than on capital. Forget eyeballs and footfalls for now.
  • If you want to buy a mid cap as a call option, bet on disruptive sectors. What are these disruptive sectors? Alternate energy, artificial intelligence, machine learning; are some of the areas where mid caps are already quite active. These are huge business opportunities and if mid caps can get their act together at this point of time they can be big beneficiaries.
  • Instead of deciding large caps versus mid caps, use this opportunity to restructure your portfolio. Don’t worry about booking losses; that is part of the game. What matters is that you are freeing up liquidity that can be fruitfully deployed in other stocks with greater potential. That should be your basic principal with respect to mid caps at this point of time.

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