Financial Planning

The largecap index, Sensex, has gained over 14% in the last twelve months, a period when midcaps have barely inched up. In fact, 50% of stocks of the midcap benchmark index are still making losses with the worst, having witnessed a wealth erosion of up to 60-70% in the past one year.

After a dream run between 2014 and 2017, midcap stocks have lost their way. As valuations sky-rocketed, midcap stock prices zoomed to life-time highs in many cases. But, things appear to be changing. Valuations, once way higher, now appear to have settled in the 'reasonable' zone once again, strengthening the case for a recovery in midcap stocks. 

Anand K Rathi
Managing Partner, Augment Capital Advisors LLP

The earnings growth in midcap stocks has sustained its growth path, compelling investors to consider midcaps once again. If this scenario plays out, smart investors should increase their allocation to midcaps in their portfolios.

Risk higher, return greater

The top 100 stocks, in terms of market capitalization, are considered as largecap stocks. The midcap stocks are those, which rank between 101st and 250th on the market cap chart. Midcap stocks have historically shown more volatility than their largecap counterparts. There is a justifiable reason for why that happens. Midcap stocks belong to mid-sized businesses, which are not as well-entrenched or well-established as large companies. However, these stocks have a bigger potential for growth compared to largecaps. This is why investors continue to search for a bargain in the midcap space, even though the risk element is certainly higher.

Nonetheless, the growth potential in midcap stocks does not make them immune to heavy volatility and downside, which can happen when economic cycles change. The spate of selling in midcaps can often reach high levels and can drag all midcap stocks down, quickly. However, quality midcap stocks always stand tall amongst fallen peers. As the Indian stock market and investors mature, we have seen the evidence of how bettergoverned midcap companies, with a sustainable economic moat and superior financials, can navigate downturns much better.

Valuations turn appealing

It is indeed true that midcap stocks turned expensive at the height of the previous run-up. The trailing price/earnings valuations of midcap indices had risen to almost 50x level in January 2018. When valuations spike, that is always a profitbooking period. In case of Indian midcap stocks, a combination of factors, including rich valuations, continued selling by foreign portfolio investors, and fear, led to midcaps coming off their highs. In the long run, the markets become a slave of earnings. While midcaps corrected, the earnings momentum in midcap stocks continued. This financial performance in effect made midcaps cheaper.

Hence, valuations of midcap stocks on the PE criteria which were once near 50x zone, have dropped to about 30-35x, creating a window of lucrative opportunities. Since midcap stocks are currently in the reasonable valuation space, a re-rating of valuations appears on the cards. A valuation re-rating happens when market participants realize they have been too harsh on a stock or a group of stocks. Research suggests that over a while, 2/3rd of equity return has come from valuation re-rating and 1/3rd has come from earnings growth. In the last two years, PE (price/earnings) valuation of the midcaps has come down as shown below, whereas, the Return on Equity (RoE) has gone up marginally.

Pockets of value clear

Given the correction in midcap stock prices and imminent PE valuation re-rating, it makes a good investment case to add midcap stocks/funds in a staggered manner over the next 4-6 months. This has to be done with an investment period of at least 3 years. Midcap stocks, once among the most expensive pieces in the Indian stock market, are now trading at a significant discount to largecaps. This discount will narrow as midcap stocks continue to perform well, in terms of earnings, and deliver faster growth.

In this backdrop, smart investors must rethink their midcap allocation. By selecting midcap mutual funds with a proven track-record and robust investment philosophy, investors can let seasoned fund managers cherry-pick midcap stocks and patiently wait for the upside. The stock selection remains the key to alpha in midcaps. A seasoned midcap-focused mutual fund scheme is a golden way to play the revival in midcap stocks. The latest opportunity will not last forever, and so investors should quickly choose the right path to midcap riches.

The writer is a Managing Partner, Augment Capital Advisors LLP 

Email : anand@augmentcapital.in
Website : www.augmentcapital.in