If you have only been watching the Sensex scale peak after peak with admiration and awe, you have missed something even more exciting: The rise and the rise in the share prices of mid-cap companies. Defined by the National Stock Exchange (NSE) as companies with a market capitalisation ranging from Rs 75 crore to Rs 750 crore, share price indices of mid-cap companies have risen by rates that dwarf the growth in the Sensex. The NSE's CNX Midcap index of 200 companies has risen by 325 per cent (from 749.75 to 3190.65) since April 2002, outperforming the 94 per cent rise in the 50-share Nifty during the same period (see graphic).
The Nifty, like the Sensex, measures the share prices of the largest companies in terms of market capitalisation. The mid-cap sector's superior performance proves two things: as a group smaller companies have given higher return to investors than bigger companies and there is much more to the stockmarket performance than what the Sensex or the Nifty show. No wonder mutual funds like Prudential ICICI, Kotak Mahindra, HSBC Fund and Cholamandalam Mutual Fund have queued up to seek SEBI's permission to launch mid-cap funds. Says Jay Prakash Sinha, asssistant vice-president (research), Kotak Securities: "Stocks of mid-cap companies have overperformed in the past couple of years because they were undervalued compared to those of other companies in their sectors." The trend has not been confined to the Indian markets. All through last year, mid-cap indices like the Russell 2000 in the US market outperformed the S&P 500 in terms of returns. The Russell 2000 almost trebled in valuation in 12 months.
But that was the story so far. Or till the end of the financial year 2004-5 to be more precise. In the past three months, mid-cap stocks have begun to lose momentum. Since April this year, the CNX Midcap 200 has risen by only 15 per cent. Is it a momentary correction? Or is it time to call it a day as far as mid-cap stocks are concerned? The verdict right now is that mid-caps won't be able to repeat their past performance-at least not the sector as a whole. "The mid- and small-cap segments are unlikely to repeat the performance of recent years since the valuation gap vis-à-vis large caps has narrowed down considerably," says Sukumar Rajah, director and chief investment officer of Franklin Templeton Investments.
The stellar performance of mid-cap companies in the past couple of years was driven by, apart from undervaluation relative to large-cap companies, increased transparency and disclosure by the companies, reduction in their interest costs and a general across-the-board rise in commodity prices. It was a rising tide of demand for mid-cap shares that lifted the prices of most stocks in the segment, often unmindful of the performance of individual companies. But rising interest rates, weakening commodity prices and high crude prices have now dampened the demand for mid-cap stocks. Although large-cap companies face the same issues they are better equipped to deal with external shocks and are not as vulnerable as smaller companies.
Market observers say that mid-cap stock valuations have been re-rated substantially vis-a-vis large-cap stocks and further movement in stock prices will depend on performance and profit growth of individual companies. While India has been traditionally a stock pickers market, the strong macro economic performance in recent years has led to a prevalence of a top-down approach in terms of market cap segments and sectors. That is, investors and funds have been buying shares of a particular segment and sector, irrespective of the company. Nilesh Shah, president of Kotak Mutual Fund, says, "After a gap of 12 months of a good phase of mid caps, there is a breather now. When signs of superior growth comes from the sector, the attention will go back to them." Even now, several emerging sectors like media and retail have no representation in the large-cap segment, which make mid-cap stocks in these industries attractive by default.
Another factor that seems to be slowing down the mid-cap bandwagon is liquidity. The longest bull run in the history of Indian stockmarkets has been largely driven by foreign money. The market makers of today are fiis which prefer stocks with easy liquidity. Though large-cap stocks provide this liquidity, mid-caps are not so liquid.
Also, there are signs that the inflow of foreign funds this year will not be able to match last year's levels. Says Shankar Sharma, director of investment banking firm First Global: "As the dollar strengthens and commodity prices weaken globally, emerging markets like India won't get as much money as they did last year." While global investors remain positive on India, corporate earnings in 2005-6 are expected to grow at only about half the rate they grew in 2004-5-only 19 per cent growth in this financial year compared with 37 per cent in 2004-5, according to Kotak Securities. This will also bring valuation of companies under pressure.
Just when mid caps seem less attractive than before, some large-cap giants are getting more popular among institutional investors-after being out of favour for a few months for different reasons. These include HLL, Colgate and Reliance Industries.
What should an investor make of all these factors? First, it is time to book profits on your mid-cap investment-whether the investment is directly in stocks or is through a mid-cap mutual fund. Second, stay away from the top-down investment approach and rather adopt a bottom-up strategy. Invest in companies with good fundamentals, no matter what market cap or sector that company belongs to.