Planning to buy mid, small-caps? Here's how to choose the winners

The mid-cap and small-cap stocks have come back in vogue following their sharp rise from March 2020 lows. Their outperformance vis-a-vis larger peers is likely to continue well into the calendar year 2021, according to analysts.

The Nifty Midcap 100 index has rallied 91 per cent from its March low, while the Nifty Smallcap 100 index has more than doubled, with a 113 per cent rise in the same period, NSE data show. This is against an 80-per cent jump in benchmark Nifty50.

Even on a year-to-date (YTD) basis, the small-cap and mid-cap indices have gained 18 per cent and 20 per cent, respectively as against an 11-per cent jump in the Nifty50.

According to a recent note by ICICI Securities, the bulk of the equity market performance since financial year 2016-17 (FY17) has been driven by a handful of stocks, while the broader indices have underperformed significantly.

"However, the tide is turning in terms of the number of stocks contributing to majority of the index performance Small-cap and midcap indices have outperformed large-caps for the first time since FY17," the brokerage said in a December 9 note.

A part of the market optimism was also fuelled by a better-than-expected July – September 2020 quarter (Q2FY21), where a number of companies benefitted from low raw material cost. READ ABOUT IT HERE

Analysts expect outperformance to last for the next one-two years, thanks to a rebound in the economic growth, influx of new investors in the market and a shift in investing trends from the mutual funds to direct equity.

"The return expectations from the large-cap universe have to be lowered going ahead. At best, large-caps can offer 8-10 per cent return whereas the right mid and small-cap stocks can offer as much as 20-30 per cent gains. Over the next one-two years, the small-caps will likely outperform their larger peers," says A K Prabhakar, head of research at IDBI Capital.

However, unlike in blue-chip stocks, one has to be extremely careful while picking the small and mid-cap names. Market analysts recommend a few parameters that one must consider while investing in the mid-and small-caps. Historical price behaviour of the stock, debt level of the company, profitability, return on equity (ROE), price-to-earnings (PE) multiples, balance sheet strength and promoter quality are among the top criteria that analysts advise investors to check before putting in their hard-earned money into this market segment.

"Investors must look at where a particular company stands in the industry along with its debt servicing capabilities and whether it is generating consistent profit. If a company's ROE is above 15, then it is worth looking at that stock. One needs to be even more careful with the smaller companies. Balance-sheet strength and the promoter quality / track record of the promoter are two must-check parameters," Prabhakar advises.

On the other hand, G Chokkalingam, founder and chief investment officer at Equinomics Research also stresses on the importance of looking at promoter holdings. He advised going for stocks wherein promoters have at least 40 per cent stake in the company, reflecting their commitment for the company.

"Investors must also look at the debt-equity ratio, working capital management and PE multiples before picking a stock," Chokkalingam adds.