Raise The Flag Of Caution In Mid-caps

When you see the stock-market highs churning out more than a few dozen multi-baggers in less than a year, you better watch for signs of froth. Scores of small investors, looking for a quick buck, have been betting big on mid-cap stocks, and yes, multi-baggers. To be sure, there have been quite a few gainers in the mid-cap space last year, but the market scenario points more to over-speculation than any fundamental changes in the mid-cap and small-cap spaces. Say experts: “It’s time to raise the flag of caution.”

Over the past year, the BSE mid- and small-cap indices have dipped by a shade over 5 per cent each, compared to the bellwether Sensex’s fall of about 17 per cent. But that does not tell the entire story. Over hundreds of stocks in the mid- and small-cap space have been hitting upper circuits despite the fact that the frontline indices were scraping their lows.

Market watchers point out that, when the frontline indices are trading at their past average valuations of around 18 times earnings, the mid-cap index, about a month ago, hit the high-valuation zone seen during the heady days of the 2008 bull market — of over 28 times earnings. Mid-caps have since corrected somewhat, but the froth is still being thrown up.

This segment is prone to more speculation than large-caps. Says U.R. Bhat, founder, Dalton Capital: “Retail invesors come at a time when the markets are going through a good phase and when the mid- and small-cap stocks, which small brokers keep peddling, have gained momentum. Mid-caps then start hitting upper circuits and double in 3-4 months. That is what attracts retail investors because typically the large-cap space does not see all this.”

By contrast, large-cap companies just move, typically, around 5 to 10 percent. This tends to make it a boring segment for retail investors. Experts also point out that investors tend to get carried away with the fact that everybody else, including neighbours, are making money in mid-caps. So, more retail investors are caught in the rush to jump in and make a quick buck.

Experts also point out that when the tide turns, this segment is impacted the most. First, liquidity in these counters dry up and stocks begin to hit lower circuits. Investors, who in the frenzy bought into these stocks, are unable to find a buyer and, therefore, are saddled with companies that more often turn out to be duds.

Just a few hundred shares selling can sometimes make these stocks hit lower circuits. Says Bhat: “Often this space is known for sub-par practices, and left with unhappy investors. In fact, quite often it’s the same companies that keep running up in the next bull market.”

Besides, this is also where large-cap investors generally do not invest because most of these companies are under-researched and may not be open to questions and the rigorous follow-ups of analysts. Institutions such as mutual funds take informed decisions where the management is open, say experts. This also puts the mid-cap space at a slight disadvantage in terms of disclosures.

A big disadvantage is that mid-cap stocks typically are promoter-run, say experts. While some of them are operating in good businesses, most of them do not have the advantage of size and may not be able to borrow at reasonable rates. Experts also point out that some operate in small niche segments and areas that cannot be scaled up to a national level. Hence, investors should always be cautious about the mid-cap and small-cap arenas.

To be sure, the mid-cap space does have some benefits. But that comes only with long-term and patient holding of quality companies. Says Andrew Holland, CEO, Ambit Investment Advisors, Ambit Capital: “In any market, people get enthusiastic. They first see the large-caps do well. Then everyone starts looking at mid-caps and everyone has a story and it becomes a bit frothy for no real reason. In all of that, what happens is that the good companies get tarred with the same brush.”

One of the most critical aspects of mid-caps, which experts say that investors must watch for, is “management bandwidth”. This determines whether a company can scale up and grow or whether it is just another also-ran. Says Holland: “Management is the key. If you have to become a large-cap from a mid-cap, you have to have depth in the management.”

Another crucial factor is corporate governance. Many mid-caps are promoter-driven and some decisions do not always keep in mind the small and retail investor. Market watchers say that investors could keep an eye out for reasonably good explanations of the major decisions taken by promoters.

Mid-cap investing is all about picking and choosing the right stocks, and staying with them for the long term. Says Holland: “Mid-caps really is about good management, and good stock picking. I look at the companies I like and if their valuations have come down, I look at it as an opportunity rather than saying mid-caps are bad now because prices have fallen.”

Typically, mid-cap investing can be very rewarding over years as companies can grow into large businesses. But, for that, investors have to invest in and buy only the quality names, not all and sundry stocks which keep racing up and down. Says Motilal Oswal, chairman, Motilal Oswal Securities: “Mid-caps offer huge opportunities to investors because many multi-bagger names come from this segment. You should not panic about price movements if you have conviction and quality stocks.”

Among the other things investors must do is avoid chasing tips. Instead, do some thorough homework on the stocks you may wish to purchase. Says Bhat: “People spend much time researching the cars or television sets they want to buy, but seldom do so when buying stocks. Instead, they end up buying on the basis of tips.”

Among the things to look for, as always, is whether the business is growing and whether the company has good products. You also need to know whether the market size is expanding, and whether the business can capture a bigger market share. Says Bhat: “These are commonsensical points, but, ultimately, this is how companies have succeeded over time.” And this is how investors can succeed in the mid-cap space too.

(This story was published in BW | Businessworld Issue Dated 08-02-2016)