The mid-cap segment has been highly volatile over the past six months, more so from September. While mid- and small-cap indices are down 15-20 per cent from their peaks, individual stocks have been hammered to the 15-80 per cent. With a few global brokerages talking about earnings downgrades for blue-chip indices, will the financial performance of mid-caps too warrant a similar move from equity analysts?

Was the stupendous rally in the mid-cap space from late 2013 to early 2018 a bubble — up-move not supported by underlying fundamentals, specifically profit growth? Are valuations still frothy in the mid-cap space?

How do retail investors participate in any rally in the risky mid- and small-cap segments?

To answer these questions, we analysed the performance of the constituents of the BSE 400 MidSmall Cap Index — a benchmark with 150 mid-cap firms and 250 small-cap companies, classified according to the recent SEBI norms. The financial performance, valuations and stock price movements of this universe was considered. The analysis pertains to the 2013-2018 period — when the rally took wings.

Here are a few key takeaways.

Profit growth drives index

The BSE MidSmall Cap index has rallied at an annual rate of 19 per cent over the past five years — November 2013-November 2018. At the index level, valuations have corrected from a five-year average of 46 times to 36 times the trailing earnings currently.

The rally over the past five years has been backed by solid earnings growth of the constituent companies. At the aggregate level, the earnings decelerated 12.4 per cent annually over the past five years. But that would be a misleading assessment of the underlying fundamentals of the index.

If the public sector banks are excluded, profits of the rest of the companies have grown at a robust rate of 37.1 per cent annually. The loss-making mid-sized PSBs have seriously hurt the aggregate picture.

Again, apart from the PSBs, if all the currently loss-making firms from the problematic infrastructure, power and capital goods sectors are taken out of the analysis, the profit CAGR has been a healthy 32.5 per cent over the last five years. The total number of such loss-making companies is 44 per cent, or 11 per cent of the 400 firms in the index.

Clearly, apart from the banking sector and a few debt-troubled firms, the growth has been reasonably healthy for most companies in the index. Also, given the solid earnings growth, it is no wonder that these stocks soared and valuations zoomed. The momentum in profit growth is still healthy, though the pace is a tad slower.

In the first half of this fiscal, the mid- and small-cap indices fell steeply by 15-25 per cent. But in this period, excluding the 44 companies mentioned earlier, the sales growth has been 12.5 per cent for the remaining 356 companies and net profit growth was 25.5 per cent compared with the first half of FY18.

Market rewards sound fundamentals

Even as mid- and small-cap indices rallied massively over the 2013-18 period, the market has discriminated between companies with strong earnings growth and those struggling with profitability or are loss-making. Higher the profit growth of firms, higher has been the returns delivered by them.

The stocks of the 61 companies in the index that recorded an annual profit growth of zero to less than 10 per cent over FY13-FY18 rallied by a CAGR of around 14 per cent on an average over the last five years. Stocks in this bucket include Crisil, Godrej Industries, Shriram City Union and Oracle Financial Services Software.

Now, 95 firms recorded annual profit growth of 10-20 per cent over this period. These firms delivered 28 per cent returns on an average annually in the last five years. For instance, Amara Raja Batteries, Somany Ceramics and Monsanto India that recorded profit growth of 10-20 per cent, delivered 20-30 per cent returns (stock prices) annually over the past five years.

The 43 companies that delivered 20-30 per cent earnings growth saw their stock prices rally on an average by 39 per cent annually. Dalmia Bharat, Symphony and Abbott India feature in this list, and the shares delivered 39-77 per cent CAGR over this period.

Progressively, if we get to the 70 firms that delivered profit growth of more than 30 per cent, their stocks performed exceedingly well and delivered compounded annual returns of 46 per cent on an average. Market favourites such as KEI Industries, Graphite India, PI Industries and HEG feature in this category.

On the other hand, for the 116 companies that reported declining profits or slipped into losses, the average return over the 2013-18 period has been a measly 9 per cent annually, with many witnessing serious correction in prices. The market has clearly rewarded those firms with a demonstrated ability to deliver profit growth consistently in these five years, while punishing those that had weak bottom-lines and losses. Of course, there are a few individual players in each earnings band that have defied the broad trend and may have been rewarded or punished disproportionately by the market, but the broad trend in stock price movements has been in line with companies’ earnings performance.

One heartening aspect of the index was that as many as 208 firms, or more than half the firms in the BSE 400 MidSmall Cap index, have reported 10 per cent to more than 30 per cent profit increase annually over these five financial years. So, much of the rally in the mid- and small-cap stocks is not totally out of sync with the underlying fundamentals.

Valuations weak for most

Among the index constituents, as many as 240 stocks or 60 per cent of the firms trade, are currently trading at a discount to their five-year price-earnings multiples. Thus, the de-rating in stocks has been quite widespread and broad-based. Given that more than half the firms delivered reasonably good profit growth, the market may have punished some fundamentally-sound stocks as well during the recent rout.

Less than a fourth, or 97 companies in the index, trade at a premium to their five-year PE multiples. These include companies from segments such as IT, pharmaceuticals, agrochemicals/pesticide manufacturers, cement players and select capital goods firms.

Just 19 companies trade at almost the same valuation multiples that they traded five years ago.

The remaining 44 firms are excluded, as they reported losses; calculating their PE ratios is not possible.

At a broad level, the questions that we had sought to answer at the outset get clarified by the analysis of the numbers as given earlier.

Going by the valuation differential enjoyed by the BSE 400 MidSmall Cap index constituents, it is clear that at a broad level, majority of the companies do not seem to enjoy unusually high or frothy valuation premium, going by their five-year average valuation.

Rallies in most stocks are justified by the underlying financial robustness or otherwise of these firms and the market has been quick to punish those with weaker fundamentals.

The only concern is that the smaller size of these businesses makes them more vulnerable in cyclical down-turns in the respective industries. It is for this reason that these stocks have typically traded at a discount to their larger peers.

Retail investors may find that the mid- and small-cap space is a maze and may not be well-placed to pick the winners from those that have less robust businesses or are financially not sound.

Hence, investing in safe mid- and small-cap funds would enable them to participate in any major rally in the space. An analysis of the most suitable mid- and small-cap funds for investors with a moderate risk appetite is given below.

The mutual-fund route to mid-cap investing

Periodic exposure by way of SIPs with a time horizon of five-plus years would be ideal

It is relatively safe for investors to take the mutual fund route while taking exposure to stocks in the mid- and small-cap space. Given the inherent volatility in these segments, with massive rallies and sharp corrections, those with a moderate risk appetite are better off making conservative bets.

In this regard, we have chosen four funds — two each from the mid- and small-cap segments — that are likely to pay off over the long term of seven-plus years.

We have picked funds that have consistently protected downsides during periods of heavy volatility over the last seven to eight years — Dec 2010-Dec 2011, 2013, Jan 2015-Feb 2016 and Feb-Oct 2018 — when mid- and small-cap indices corrected by 15-30 per cent. These funds have beaten their respective benchmarks consistently over one-, three-, five- and seven-year time-frames, but may not necessarily be chart-toppers, especially in the case of the mid-cap schemes.

Reliance Small Cap and SBI Small Cap

Rarely do small-cap funds participate in all rallies and protect downsides during corrections, across cycles. Reliance Small Cap and SBI Small Cap are two such schemes that have fulfilled these conditions consistently.

Investors with a horizon of seven-plus years can buy units of the funds through the SIP route — Reliance Small Cap stopped accepting lump-sums from March. In any case, it will be better if a mid- or small-cap fund is bought on a periodic basis, rather than as lump sum, given the inherent volatility of stocks in the space.

Over one, three and five years, both the schemes have outperformed their benchmark — BSE Small Cap TRI index. The extent of outperformance vis-à-vis its benchmark has been to the tune of 5-10 percentage points. In the last five years, these funds delivered 30-31 per cent annual returns.

Both schemes take a fairly diffused approach to individual holdings in the portfolio. Individual stocks mostly account for 3-4 per cent of their portfolios. Reliance Small Cap holds as many as 80 stocks across market cycles, thus making the portfolio quite diversified and non-concentrated. SBI maintains a portfolio of just over 40 stocks. The schemes take cash and debt positions to the extent of 13 per cent of their portfolios during heavy corrections, which prevents erosion in the funds’ NAVs.

Both the schemes have avoided or kept exposure to banks and financial services companies to very low levels over the past few years, which means that they have been immune to the NPA-led carnage in the segment. Instead, consumer non-durables, consumer durables, chemicals and select capital goods are key holdings — all of which have rallied well in the past five years.

The stock picks are a mix of momentum and value strategies. But most companies in the lists are quality names.

Franklin India Prima and DSP Midcap

Both these schemes are middle-of-the-road performers, but have a proven ability to contain downsides during steep corrections and index-beating returns over five to seven years.

Franklin Prima has a track record of nearly 25 years and has delivered close to 20 per cent annually over this period. It may underperform in short-term rallies, but outperforms to the tune of 2-4 percentage points vis-à-vis its benchmark over five- and seven-year periods. DSP Midcap, too, has consistently outperformed across periods and does take conservative bets during corrections, making its portfolio relatively immune during volatile markets.

Both schemes hold large-caps to the extent of 15 per cent of their portfolios and take cash and debt positions to the tune of 7-9 per cent, especially during falling markets, which prevents erosion in NAVs. Holdings are spread over 50-60 stocks for these funds and exposure to individual names is generally restricted to less than 5 per cent. DSP Midcap reduced exposure to banks and financial services companies over the past few years, which helped it protect the portfolio from massive selling in those segments.

Increasing exposure to consumer non-durables helped Franklin Prima contain downsides. Though both funds do hold banks in their portfolios, the exposure is restricted to quality names such as RBL Bank, City Union Bank, HDFC Bank and Kotak Mahindra Bank.

Investment through the SIP route with a time horizon of five-plus years will be the best mode to benefit from these funds.