Mid-Cap A Feature On Blue Chips In the Making

For an investor looking for a multi bagger idea to invest in, mid cap stocks provide the correct opportunity. It has always been observed that good mid cap companies provide the best opportunity for capital appreciation. According to a research report, among the BSE 500 companies, which have given more than five time returns over the last seven years, almost 80 per cent are midcaps. For example companies like Emami, Gruh Finance, Zydus Wellness etc have appreciated by more than five times during the same period. However, when we look at the short term performance of mid cap companies we find that mid cap stocks are more prone to the vagaries of stock market fluctuations. What this essentially means is that when the overall market is rising; mid cap stocks tend to outperform the broader market, whereas in a falling market their fall is faster and steeper than the broader market. For example last year (CY11) when sentiments were not very favourable for the stock market, the CNX Midcap Index fell by 31 per cent whereas in the same period the broader S&P CNX Nifty was down by 25 per cent. The situation got reversed with the start of the year 2012, when the stock market started to rise. If we look at the year till date performance, CNX Midcap is up by 15 per cent compared to a mere six per cent up move in the CNX Nifty.

The reason for a bad performance of the midcap index may be attributed to the bad financial performance of midcap companies owing to the low pricing power that they had and their weak balance sheets. Deterioration in their profitability is steeper, which is reflected in stock prices. If we analyse the performance of 61 mid cap companies that have announced their fourth quarter (Q4FY12) results we find that on a standalone basis their net profit has declined by six per cent on a Y-o-Y basis. Even if we look at number of companies that have witnessed their profits declining, it is almost 50 per cent and 27 out of 61 companies have seen their profit being lower than that of last year during the same quarter. However, during the same period sales have witnessed a jump of 25 per cent. The reason for such a bad performance on the net profit front can be attributed to a rise in the raw material cost and the interest burden. For the same companies interest cost has increased by a whopping 41 per cent on a yearly basis. The reason for such a rise may be attributed to a hike in key policy rates by Reserve Bank of India (13 times since March 2010) to control inflation. This has increased the cost of funds for companies.

When are Mid Caps a Good Opportunity?

So does this means that mid cap represents opportunity only in rising market and in shorter time periods? We do not believe so, viewed over shorter periods of time, these periods of growth followed by corrections could be seen as short term opportunity by the market but a longer term view of mid caps will show that though they react faster to the market events, they can experience significant long term growth.

The reason for such a growth is primarily due to two factors. The first, of course, is that there is real growth, as mid cap companies are in the process of scaling up their businesses grabbing the larger opportunities. The second factor is a lower base. As mid cap companies have lower turnover their growth rate seems to be larger. But as these companies become large caps, though their growth rate comes down so does the volatility in their earnings and provides a stable return to investors. To cite an example, a company like Jubilant Foodworks has seen its operating income grow at a compounded rate of 48 per cent for the five years ending FY11 and net earnings in the same period has grown at an astounding rate of 104 per cent. The bottomline has grown from Rs 2.02 crore in FY06 to Rs 72 crore in FY11.

What is also important from an investor point of view is the breadth and the depth of mid cap companies that can be found across sectors and one can create a well diversified mid cap portfolio. While individual mid cap stocks may be impacted by the adverse market conditions, it is quite possible to build a portfolio of mid cap stocks that will thrive irrespective of market movements.

The Future

Going forward what will drive the performance of the mid cap companies is the unique position and stage of economic development at which the Indian economy stands. Developing countries like India are in a transition phase and are well positioned to nurture mid cap companies. As our economy develops it opens up new business opportunities and sectors which spawn new mid cap companies. And as these sectors mature, mid caps in these sectors will grow into mature large cap stocks. Befitting examples of this is the Indian IT sector during the 1990’s and the telecom sector during 2000’s, which saw companies like Infosys and Bharti Airtel emerging as large cap companies and in their transition from mid cap to large cap they handsomely rewarded their investors. Therefore investors should have confidence in mid cap companies that are aspiring leaders in their sector. Moreover, in the current situation one must be patient with one’s investments as the worst may not be behind us and it will take a few more quarters before situation normalizes. However, once the economy returns to normal, these mid cap stocks will go back to the high growth phase and start delivering better returns than the broader market.