Don’t believe the mid-cap myths

Mid and small-cap stocks are now the flavour of the market and market experts offer many reasons to buy them from their ‘attractive’ valuations to the FIIs simply lapping them up.

But running a check on the NSE-listed companies based on their valuations, financials and shareholding patterns to help sift fact from fiction, here’s what we found.

Proponents of smaller stocks argue that with blue-chips already soaring past their 2008 highs, it is only a matter of time before mid- and small-cap stocks follow in their wake. They point to the valuation gap between the bluechips and the rest of market, and argue that it is only a matter of time before mid and small-cap stocks catch up.

But the truth is that the stock market rally from August last year has already narrowed the valuation gap between the large-cap stocks and their mid-cap peers. Taking stock of the PEs of nearly 1,200 stocks, large-cap stocks (more than ₹7,500 crore in market cap) sport an average PE of about 19 times after this rally. The average PE for the mid-caps (₹2,500 crore to ₹7,500 crore) is not very different.

This suggests that mid-cap stocks as a class are already done with most of their ‘catching up’ with blue-chips and offer little headroom to rise further. If at all any segment of the market is still trading at a discount, it is small-cap stocks (less than ₹2,500 crore).

But a low PE here may go with dodgy fundamentals. In any case, mid and small-caps do deserve to trade at a sizeable discount to large-caps owing to these companies’ smaller scale of operations, greater vulnerability to interest rates and their poor liquidity on the bourses, which dampens institutional interest.

Note that in the past, whenever mid or small-cap indices have actually caught up with the Sensex in terms of PE multiple, it has presaged a correction.

The other argument trotted out in favour of mid- and small-caps is that many of them are available cheap. Yes, even after this rally, one in five stocks in the mid-cap universe and one in every three among small-caps, trades at a single digit PE. In contrast, half the large-caps sport PEs of over 20.

But from the financials of NSE-listed companies, it is clear that large-cap companies deserve better valuations as they have navigated this bruising downturn far better than their smaller rivals. While large-cap companies managed a 19 per cent growth in their sales and an 11 per cent growth in net profits in the last three years, a nasty period for the economy, mid-cap companies struggled with a 4 per cent profit growth. Their sales growth remained reasonably healthy at 17 per cent.

But small-cap companies present a sorry picture. Their sales expanded at about 12 per cent but their aggregate profits of three years ago had turned into losses by last fiscal.

Is past performance really relevant, you may ask, when this rally is based entirely on the hope of a dramatic turnaround? True, fundamental factors have so far taken a back seat in this election-driven bull-run, with investors re-rating the PE multiples of all stocks.

However most bull markets begin with bottom-fishing, where investors buy the most beaten-down stocks without paying much heed to their profits or cash flows. Once stock valuations reach normal levels and the easy pickings are gone from the market, the spotlight turns to fundamental factors such as profit growth, ability to service debt and cash flows.

The initial leg of the 2009 market rally was also led by low PE (and low quality stocks), but the initial set of gainers didn’t maintain their momentum.

Therefore, if this bull run continues, be sure that low-quality mid- and small-caps stocks will quickly pass on the baton to quality stocks with better prospects.

A final misconception about this rally has been that FIIs, tiring of blue-chips, have been aggressively accumulating mid- and small-caps, particularly from the cyclical sectors. That’s not true, either.

Shareholding patterns for the last one year show that it was large-cap stocks which FIIs most avidly bought in the last one year.

The average FII stake in NSE-listed large-cap stocks rose from 17.7 per cent in March 2013, to 18.9 per cent by March 2014.

In contrast, the average FII holding in mid-cap stocks stayed almost flat at 5.08 per cent (5.05 per cent a year ago). In the case of small-caps, the average FII holding actually fell from 3.43 per cent to 3.3 per cent, as FIIs frenetically churned their small-cap portfolio, but refrained from adding to it.

Nor did FIIs display any marked preference for cyclical or core economy sectors, when they shopped for mid- or small-caps.

Consumer companies jostled with realtors and software among the mid-cap stocks where FIIs sharply pegged up their ownership in the last one year.

AstraZeneca Pharma, Page Industries, Kajaria Ceramics and Omaxe saw the most FII purchases in this period, while Hexaware, Jain Irrigation, Sintex and Dena Bank saw FIIs exit.

In the small-cap space too, stocks which saw the most increases in FII holdings — Hinduja Foundries, JMT Auto, Ashapura Minechem, Thomas Cook, NRB Bearings, PVR, ICRA and CEAT — demonstrated no common sectoral theme. In fact, FIIs also simultaneously pruned their holdings sharply in S Kumars, IVRCL, Simplex Projects, Nitco and LG Balakrishnan.

What this suggests is that when it comes to choosing mid- or small-cap stocks for their portfolio, FIIs aren’t really taking a bet on economic recovery or regulatory fixes that will work miracles on the cyclical sectors.

They are just buying companies that seem to have good prospects. And this is just what you should do too.