Have large-caps run out of steam?

Mid-caps put up a relatively better performance in terms of margin

In difficult times like these, investors prefer to stick with large-cap companies, as these companies have the scale and management bandwidth to survive pressures. With the big boys facing the heat of a tough operating environment, the small and mid-cap stocks should be in for deeper trouble, right? Not really. Several brokerages have come out with reports that are betting on the mid-cap universe as their earnings revision has been rather stable.

From a valuation perspective, mid-caps are currently trading at 33 per cent discount to large caps as against 15 per cent in September 2010. On an absolute basis, The BSE Midcap Index is trading at 10x one-year forward price/earnings multiple, which is at a discount to its long-term average of 11x. Clearly, these companies are available cheap right now.

But, there’s more to these companies than valuations. Interestingly, Macquarie’s research shows that while operating margins for both Sensex and BSE-100 companies have been declining since the beginning of the decade, the degree of decline in the broader index is less than in the large-cap index. According to Macquarie, “Since 2003, operating margins for the Sensex have come off by around 10 percentage points (on a consolidated basis) compared to around 300 basis points for the broader BSE-100 index. In midcaps, while aggregate operating margins declined by 300 basis points in the first half of the decade, it recovered in the second half by 400 basis points by end of FY10.”

Clearly, as tariffs fell from a peak of 150 per cent in 1991-92 to 10 per cent at present, Indian companies have been faced with stiff competition from cheaper imported goods. But as the economy opened, competition increased, imports became cheaper and the erstwhile small and medium companies captured market share, the operating margins of Sensex companies began to shrink and have now slowly started to converge with the BSE-100 universe.

But this does not mean that all mid-caps are in for a good run. As corporate India is faced with the problem of rising interest rate and commodity inflation, stock picking is more important than market timing. Cheap valuation should not be the only reason to buy mid-caps. Edelweiss Capital has adopted a mix of top-down and bottom-up approach to select top ten mid-cap stocks, broadly classifying them under three investment buckets. The first theme looks at stocks that will benefit from cyclical recovery. Edelweiss believes that fall in commodity prices/interest rates will positively impact companies like Oberoi Realty, Sadbhav Engineering and Ramky Infra. The second theme is the consumption theme, whereby companies that focus on domestic consumption growth will benefit like Jagran Prakashan, Jet Airways, VIP Industries. The third theme looks at buying growth at reasonable price.