Is there value left in mid-cap stocks?

If earnings trajectory is strong and the stock appears inexpensive, it can re-rate further

India has perpetually been a bottom up story, despite macro headwinds. FII investors who are slightly underweight on India, currently do not pause to ponder over investing into any sound mid-cap stock.

The domestic mutual fund managers are also fancying high growth mid-cap stories. Hence, we believe that good mid-cap stocks will continue to offer wealth creation opportunity for the investors.

However, one needs to be a long-term and disciplined investor to become a successful mid-cap investor. This combination has the potential to create enough wealth for investors in this equity market.

Indian markets are on an upward trajectory, with the Nifty having returned 26 per cent Year-to-Date (YTD) and having already surpassed the 10,000 level; Midcap India Index is also sitting pretty on 50 per cent YTD returns. This strong performance is in part driven by robust inflows in Indian equities in CY 2017 until October.

The valuations have become slightly challenging with broad earnings recovery likely to be back ended; although, if we look at it granularly, in pockets of automobiles, private banks and Non-Banking Financial Companies (NBFCs), we can see earnings growth of 15-20 per cent, while IT, Telecom, PSU banks will deliver muted growth, dragging down the overall earnings growth.

The market is recognising the same and is giving premium multiples where earnings growth is visible.

We believe, markets are discounting good monsoons , continuity of flows, smooth implementation of GST , lower interest rates and above all, the continuity of NDAGovernment post 2019, ensuring endurance of policy and reforms.

Given this background, we continue to prefer the broader Consumption/Discretionary Theme. As a house, we try to work on liquid mid-cap ideas, which are poised to deliver robust 35-50 per cent earnings CAGR over FY17-20E and have a return potential of 40-50 per cent from current levels.

It is also important to analyse the risk reward while investing into mid-cap stocks. The stock performance could be volatile in different earnings cycles.

Because of low liquidity, the volatility is higher in mid-cap stocks.

However, if one has invested in the right business and management, they can be rest assured that the cycle will turn faster for these companies. Hence, the stock disappointment too gets reversed rapidly.

Growth potential

If one were to analyse the size of the opportunity in mid-cap investing, here is a simple data point. It took 25 years for the Indian GDP to rise by $2 trillion. Now we expect the same incremental GDP in next five years. The market capitalisation of equity markets will rise accordingly with massive outperformance expected from mid-cap stocks.

There is a challenge as well that a lot of mid cap stocks have rallied already. It is important to understand whether there still is some value left in those stocks.

If the earnings trajectory is strong and the stock appears inexpensive on relative basis, PEG ratio among others, there is still a large scope of further re-rating.

Another common thing is that the earnings are not dependent on cyclical nature of the economy. They are operating in the consumer discretionary space and playing on urbanisation, nuclearisation, home improvement and residential construction.

In our view, the investors will pursue growth stocks in the currently charged up market.

The writer is Managing Director, Emkay Global Financial Services

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