 "Flexi-cap funds mimic large-cap schemes")
Many of the large flexi-cap funds have shifted decisively towards large-cap stocks and have a lower allocation to mid-caps than, say, three years ago, when the mid-cap rally began. Fund managers attribute this shift in allocation to the altered growth prospects and valuations of these two sets of stocks.
The run-up in mid-caps has made these stocks expensive. While the Nifty is currently trading at a 12-month trailing price to earnings (P/E) ratio of 23.73, the Nifty Free Float Midcap 100 Index is at a P/E of 35.12. The market remains optimistic about these stocks. “The higher valuations of mid-caps is driven by the market’s optimism about recovery in growth; expectations of sustained rate cuts, which would benefit mid-caps more than large-caps; and expectations of a sustained rate cut cycle that would drive better earnings growth for mid-caps. Also, when the economy is expanding, mid-caps have higher growth opportunities,” says Gautam Sinha Roy, vice-president and fund manager at Motilal Oswal AMC. Despite the market's exposure, fund managers have cut exposure in these stocks wherever valuations seemed too high. “They don’t want to be caught on the wrong foot in case of a downturn in this space,” says financial planner Arnav Pandya.
Various other factors have led to the higher weight of large-caps in the portfolios of flexi-cap funds. The market caps of many of the mid-cap stocks that fund managers held have grown much larger, owing to the run-up over the past three years. They have turned into large-caps now. These include companies such as Eicher Motors and Britannia Industries. In case of many mid-cap stocks, while valuations have gone up, growth prospects have come down. So, fund managers have had to cull them from their portfolios. Where the growth prospects remain intact, they have reduced exposure as a matter of prudence owing to expensive valuation.
Managers of flexi-cap fund managers, however, warn that investors should not decide where to invest based solely on aggregate P/E numbers, as these can be deceptive. “Among large caps, there are many resource companies, such as those belonging to oil & gas, coal and power utilities, which always trade at a P/E of 8-12x. Also, many large-cap companies have made the wrong capital allocation decisions in the recent past. This has affected their cash flows and return ratios, and led to their de-rating,” says Atul Bhole, vice-president and fund manager, DSP BlackRock Mutual Fund. Because of these factors, he says, the large-cap universe looks cheaper on an average.
Fund managers continue to have faith in mid-caps. “In the case of mid-caps, there are many focused companies in the consumer discretionary sector, pharma and auto ancillary sector which are doing well in terms of growth and return ratios. These mid-caps deserve their valuations,” says Bhole. Among large-caps, he is looking at auto companies, and banks, mostly private. He believes if a broad-based earnings turnaround happens, large public-sector banks will benefit as they are approaching the end of the non-performing asset recognition cycle and have also made treasury gains due to the G-Sec rally.
Fund managers look for stocks with high earnings growth prospects and good return ratios, which are available at attractive valuations. If you invest directly, follow a similar approach. “Mutual fund investors should stick to their asset allocation. Cut your exposure to the mid-cap space if your exposure to them has risen beyond what your risk appetite warrants. But, do not exit this space entirely as these stocks can continue to outperform for a long time. If they don’t want to take decisions regarding market cap, they should go with a flexi-cap fund with a good track record,” says Manoj Nagpal, chief executive officer, Outlook Asia Capital.
The run-up in mid-caps has made these stocks expensive. While the Nifty is currently trading at a 12-month trailing price to earnings (P/E) ratio of 23.73, the Nifty Free Float Midcap 100 Index is at a P/E of 35.12. The market remains optimistic about these stocks. “The higher valuations of mid-caps is driven by the market’s optimism about recovery in growth; expectations of sustained rate cuts, which would benefit mid-caps more than large-caps; and expectations of a sustained rate cut cycle that would drive better earnings growth for mid-caps. Also, when the economy is expanding, mid-caps have higher growth opportunities,” says Gautam Sinha Roy, vice-president and fund manager at Motilal Oswal AMC. Despite the market's exposure, fund managers have cut exposure in these stocks wherever valuations seemed too high. “They don’t want to be caught on the wrong foot in case of a downturn in this space,” says financial planner Arnav Pandya.
Various other factors have led to the higher weight of large-caps in the portfolios of flexi-cap funds. The market caps of many of the mid-cap stocks that fund managers held have grown much larger, owing to the run-up over the past three years. They have turned into large-caps now. These include companies such as Eicher Motors and Britannia Industries. In case of many mid-cap stocks, while valuations have gone up, growth prospects have come down. So, fund managers have had to cull them from their portfolios. Where the growth prospects remain intact, they have reduced exposure as a matter of prudence owing to expensive valuation.
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Managers of flexi-cap fund managers, however, warn that investors should not decide where to invest based solely on aggregate P/E numbers, as these can be deceptive. “Among large caps, there are many resource companies, such as those belonging to oil & gas, coal and power utilities, which always trade at a P/E of 8-12x. Also, many large-cap companies have made the wrong capital allocation decisions in the recent past. This has affected their cash flows and return ratios, and led to their de-rating,” says Atul Bhole, vice-president and fund manager, DSP BlackRock Mutual Fund. Because of these factors, he says, the large-cap universe looks cheaper on an average.
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Fund managers continue to have faith in mid-caps. “In the case of mid-caps, there are many focused companies in the consumer discretionary sector, pharma and auto ancillary sector which are doing well in terms of growth and return ratios. These mid-caps deserve their valuations,” says Bhole. Among large-caps, he is looking at auto companies, and banks, mostly private. He believes if a broad-based earnings turnaround happens, large public-sector banks will benefit as they are approaching the end of the non-performing asset recognition cycle and have also made treasury gains due to the G-Sec rally.
Fund managers look for stocks with high earnings growth prospects and good return ratios, which are available at attractive valuations. If you invest directly, follow a similar approach. “Mutual fund investors should stick to their asset allocation. Cut your exposure to the mid-cap space if your exposure to them has risen beyond what your risk appetite warrants. But, do not exit this space entirely as these stocks can continue to outperform for a long time. If they don’t want to take decisions regarding market cap, they should go with a flexi-cap fund with a good track record,” says Manoj Nagpal, chief executive officer, Outlook Asia Capital.