There is opportunity in midcap stocks

Now is the time for investors to take exposure in this category through MFs

Over the past few weeks, we have seen the deepest of the corrections in the small- and mid-capitalisation space since the post-demonetisation correction in November 16. Let us analyse the reasons and opportunities from it for long-term investors.

Correction and learning

On a year-to-date basis, as of June 20, 2018, the large-cap index (Nifty50) gained ~2.3 per cent while the mid-cap and small-cap indices (Nifty Midcap 100 and Nifty Smallcap) declined 12 per cent and 17.5 per cent respectively.

The correction in individual stocks has been quite notable. Among the constituents of the mid-cap index, 40 per cent of the stocks have lost at least a quarter of their market capitalisation from their highs. This number stands at 70 per cent for those of small-cap index.

During the same time period, mid-cap mutual funds have fallen ~8.5 per cent, on an average, thereby out-performing the NSE Midcap 100 index by ~3.5 per cent. The number stands at 10.5 per cent and 7 per cent for small cap. About 85 per cent of the mid-cap funds and 100 per cent of small-cap funds we track across the industry have beaten the indices.

After a calm 2017, there has been an increase in volatility, driven by both global and domestic factors — increase in inflation, rise in oil price, hike in policy rates, trade war etc. Due to a global risk-off, the foreign investors have pulled out from the emerging markets, including India. In addition, the introduction of the additional surveillance mechanism (ASM) on certain stocks by SEBI and stock exchanges has impacted liquidity adding to the selling pressure.

In the previous cycle of 2003-08, the mid-caps corrected over 10 per cent at least eight times. Two of the corrections were savage, with a 25 per cent fall in 2004 and 37 per cent in 2006. What is interesting is that the recovery of all these corrections happened in a few months time-frame. The same can be extrapolated to small-caps. The learning is that, as long as growth persists, there can be recovery in stock prices.

The GDP numbers indicate that the economy is in course for a full-fledged recovery from the twin effects of demonetisation and GST. The high frequency data points like vehicles sales, particularly the commercial vehicle sales, cement production and tax collections, among others, point to the same.

The earnings season indicates that the sales and profit growth for the broader universe of companies was in mid-teens, if one excludes PSU and corporate banks. Three out of every four companies have indicated that the demand environment is improving and they are confident about robust growth in FY-19.

As per estimates, the earnings of sizeable number of small and mid-cap companies would be high, at least for the next two to three years.

Why is there an opportunity?

India has taken eight years for its GDP to grow from ₹100,000 crore-200,000 crore, five years to reach the next trillion in FY-20 and would take less than four years for the next trillion.

This creates a lot of opportunities for companies. Also, India’s per-capita GDP crosses $2,000 in 2018, which is a significant inflection point for consumer behaviour benefitting companies.

The business environment is getting a long-term boost, through the recent reforms, to ease the doing of business like implementing GST, removing limits for foreign capital, formalising the banking channel, creating platform for trade receivables, resolution of bad loans through IBC etc.

Though the future looks good for many sectors, the ones which stand out are building materials, financials (private banks, NBFCs, asset managers, insurance etc.) and consumer discretionary.

One of the frequent arguments one hears is that the mid- and small-cap stocks are expensive. What it usually means is that the indices’ P/E is high on a trailing basis. While we may not negate it, the reason for higher valuation is because of the sub-optimal earnings of the companies due to the effects of demonetisation and GST.

These effects are behind us. As of date, the indices have lost over a quarter in terms of valuation. As growth comes back, the valuations would look attractive.

The mid- and small-cap space delivered higher returns in higher teens on a long-term basis and this comes with volatility. Post the erosion of froth in the recent correction, it is time for investors to take exposure in the categories through mutual funds. This is because, unlike 2017, when many stocks went up, there would be divergence in stock performance which the fund managers are better equipped to capitalise on.

The allocation could be small to start with and build over a period of time with the time horizon of at least three to five years.

We should remember that the money invested in the market corrections works its best to generate returns. This is one such correction — make use of it.

The writer is Co-CIO, Aditya Birla Sun Life AMC

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