As the Sensex flirts coyly with 25,000 and we kick ourselves for not stocking up on blue-chips before the election rally, market pundits remain bullish even if their focus has changed – go for mid- and small-cap stocks, they say.
The Sensex has already zoomed 16 per cent beyond its 2008 peak, but mid- and small-cap indices hover way below their highs. So ‘catch them before they zoom’ is the refrain.
But running a reality check on the returns, valuations and financials of these stocks suggests that they are no longer at a bargain.
The small-cap segment, where most of the value-buying opportunities are available today, has rather shaky fundamentals.
Nor have foreign institutional investors (FIIs), as the market believes, indiscriminately bought smaller stocks (see accompanying story).
Therefore, this is not the time to bypass blue-chips in favour of mid- or small-cap stocks .
But you still have a good chance of homing in on big wealth-creators if you select smaller stocks for their quality and prospects. Here are five ideas to identify the right ones.
Focus on prospects, not PE After the catch-up rally that has taken the BSE Mid-cap Index up by 51 per cent and the Small-cap index higher by 65 per cent since end-September 2013 (the Sensex is up 25 per cent), the most promising stocks in these segments are no longer cheap.
In fact, stocks that are still languishing at rock-bottom PEs are those with uncertain prospects or governance issues.
Therefore, to make a selection, look for companies focussed on the domestic market, which can deliver an automatic rebound in profits with a turn in the economic cycle. Auto ancillary makers, engineering, banks, NBFCs, realty, consumer appliances and entertainment are some sectors well-represented in the mid-cap and small-cap space, which may be able to deliver a quick bounce-back as the economy revs up.
Amara Raja Batteries, Tube Investments, Wabco India, V-Guard, Bajaj Electricals, Sobha Developers, Oberoi Realty, Karnataka Bank, Lakshmi Vilas Bank and City Union Bank are attractive in this space.
Sectors or companies which require regulatory reforms to repair their P&Ls or balance sheets, such as those in mining, power or infrastructure building, are best avoided at this juncture as this theme has been done to death in this rally.
Bet on the steadying rupee As the rupee went into a free fall over the last two years, companies catering to the export market earned windfall profits and were avidly chased on the bourses. But now, foreign capital has been flooding back and the rupee is steadying.
Therefore, look for companies with an import component to their operations, as they may stand to save on costs and deliver a quick improvement in profits as the rupee revives.
Sectors such as specialty chemicals and paints, print media and cement seem to be the biggest beneficiaries of this trend. In selecting stocks from these sectors, it makes sense to consider companies which have managed healthy sales growth in the last three years, as this is an indicator of the company’s ability to drive demand and hold on to its market position even in a downturn. Avoid highly leveraged companies, because the interest rate cuts that can lift their fortunes don’t appear likely anytime soon.
Stocks such as BASF India, Jagran Prakashan, DB Corp, India Cement, JK Lakshmi Cement and Ramco Cement fit the bill.
Go for sector leaders One set of mid and small-cap stocks that FIIs have aggressively bought in this buying spree, is the market leaders in niche sectors that are simply not represented in the index.
Stocks such as Thomas Cook (travel), PVR (multiplex), ICRA (rating agency), Dish TV (television) and Mahindra Holidays (time shares) have seen significant accumulation by FIIs in recent quarters.
While the bellwether indices in India are dominated by banking, IT, energy, pharma, FMCGs and mining and metals, there are scores of other promising sectors that find place only in the mid- or small-cap segments.
Education, rating agencies, multiplexes, hospitals, media and entertainment, specialty chemical makers — these sub-segments feature quality companies which lead their sectors but are, nevertheless, branded as mid-cap stocks.
Investors can play this trend by cherry-picking leading companies from sectors such as education, consumer durables, agri-business, jewellery retail, engineering, leisure and retail. Rallis India, Coromandel International, VA Tech Wabag, PVR, Specialty Restaurants, Treehouse Education, TBZ and Phoenix Mills are stocks to consider.
Follow the institutions If running through the numbers for hundreds of mid- and small-cap stocks sounds dreadfully difficult, take the short cut.
Narrow your shopping list only to stocks that institutions own. This way, you don’t have to worry about picking up a mid- or small-cap stock with doubtful fundamentals or governance issues.
Following the moves not only of FIIs but also of domestic institutional investors such as mutual funds or insurance companies may work in your favour.
While some classes of foreign investors may be in the market for quick gains, mutual funds and insurance companies are likely to have a more long-term orientation that is in sync with that of a retail investor.
Going by the latest shareholding data (end-March 2014), it is evident that both domestic mutual funds and insurance companies have been far more selective with their participation in mid- and small-cap stocks than the FIIs.
While FIIs held stakes in 614 out of the 1,060 NSE-listed small-cap stocks, mutual funds owned 544 and insurance companies held less than half this number.
Similarly, in the mid-cap space, while FIIs held stakes in almost all the NSE-listed stocks (numbering 138), mutual fund managers had bought into 125 of these and insurance companies into just 79 stocks.
Take the fund route Finally, if you’re a retail investor looking to plunge into small- or mid-cap stocks on your own, you should be aware of two risks. One, such stocks can offer you a very bumpy ride, giving you stratospheric returns in bull markets but going into a free fall at the first sign of trouble.
Two, even if you can stomach this volatility and hang on for the long term, you will have to frequently review and replace stocks in your portfolio after taking stock of their fundamentals and valuations.
Taking the mutual fund route to investing in mid- and small-cap stocks is the best way to sidestep all this effort and risk.
While there are scores of mid- and small-cap equity funds for your consideration, with most of them sporting impressive one-year returns, it would be best to opt for funds that have outperformed the CNX Midcap Index over market cycles of the last five years.
While funds with a deep value strategy and those heavily invested in cyclicals have fared well so far, it now appears prudent to buy mid-cap funds, which follow a blend of growth and value strategies. ICICI Pru Midcap, Mirae Asset Emerging Bluechip Fund, HDFC Midcap Opportunities and Franklin India High Growth Companies appear to be a few good choices.