Correction in midcaps: What you need to do to structure your portfolio

You do not really need to be a very perceptive analyst to understand that midcaps have corrected sharply since the beginning of the calendar year 2018. There have been various reasons touted for the same. While higher oil prices are being cited as one of the reasons for the midcap crash, the fall in commodities is also a key factor. Then there are technical factors like the introduction of additional special surveillance (ASM) margins, which has hit mid-cap stocks quite badly. The recent Union Budget announcement to impose capital gains on LTCG also led to a rush to book profits ahead of the 31st March deadline. Finally, the mutual fund categorization also forced many funds to sell midcaps as valuations were anyways slightly stretched.

If you look at the comparative chart above, it is quite evident that there is a huge divergence between the performance of largecap Nifty stocks and midcap stocks. In fact, in the last 7 months itself, this divergence has been to the tune of 20 per cent. That is not all. The midcap index does not really represent a heterogeneous group quite well. In reality, most midcaps have seen corrections to the tune of 40-70 per cent in the last 7 months.

Why midcaps did well in the first place since 2014?

There are some fundamental reasons why midcaps did extremely well till the end of 2017. To begin with, midcaps were less leveraged compared to the largecaps. Most of the NCLT cases are largecaps. They never had the cash flow constraints and solvency issues that largecaps faced. This enabled faster growth. Secondly, midcaps have maintained focused business models, by default. This focus on core competence has stood them in good stead in good and bad times! Lastly, midcaps enjoyed the dividends of cheap oil much more than the largecaps. That advantage got reversed when the oil bounced from $30/bbl to an interim high of $80/bbl.

That brings us to the key question; what should be your midcap strategy and how to separate the wheat from the chaff? While midcaps will continue to be intrinsically risky, the lower valuations do give a level of comfort. Here is a 6 point strategy for you to follow with respect to midcaps:

• Remember, not all midcaps are bad. Of course, you need to be cautious of the stocks that have been falling vertically and are beset with larger problems of corporate governance. Otherwise, it is these midcaps that still hold the potential to become the largecaps of the future. Firstly, get rid of the corporate governance issue companies.

• Secondly, focus on midcaps that have held value in bad times. When the entire midcap space has corrected nearly 20 per cent, there must be stocks that have corrected just about 10 per cent. Find out why this dichotomy and stick to strength. These are the stock that will fly once the reversal commences.

• Keep an eye on the midcaps that are growing in profitability and margins. You really cannot go wrong on these. When this is combined with scale, you have a winning a recipe for a long-term wealth creator. Remember, it is midcaps like Lupin, Britannia and Havells that have become multi-baggers in the last 10-15 years.

• Focus on midcaps that are low on debt and on equity. Both are equally bad. If the former reduces your solvency, the latter dilutes your equity base. A midcap stock cannot afford either of these scenarios. Prefer lean and mean midcaps that work on cash flows rather than on capital.

• Are the midcaps operating in disruptive sectors? Alternate energy, artificial intelligence, machine learning; are some of the areas where midcaps are already quite active. These are potentially huge business opportunities and midcaps that can get their act together at this point of time can be the big beneficiaries.

• Finally, this is the time to restructure your portfolio. Don’t worry about how much losses you are booking. What matters is that you are freeing up liquidity that can be fruitfully deployed in other stocks with greater potential. That should be your guiding light with respect to midcaps at this point of time.

The writer is Senior Equity Research Analyst with Angel Broking Ltd.