Betting on mid-caps

TORCH-LIGHT

The 1000-point rally that the BSE Sensex witnessed from the level of 4700 has been an unusual one. Unlike previous rallies, when the rally was led primarily by the large-cap pack, none of the big boys (barring Infosys to some extent) has contributed significantly to this rally. The backbone of this rally has been mid-caps.

We have always backed mid-cap stocks over large-caps on most occasions in the cash market. Mid-caps offer leveraging opportunities in the derivatives market, and given that most of them are high-Beta stocks, that's where, we believe, the killings should be made.

Another big advantage with mid-cap stocks is that, if picked at the right time and price, they can provide windfall gains, which in percentage terms will far exceed that of the relatively higher priced large-cap stocks.

Given this backdrop, let us zero in on three mid-cap stocks that have rewarded investors thus far - Ipca Labs, Neyveli Lignite Corp (NLC) and Hindustan Zinc (HZL).

Ipca has restructured its domestic business to focus on its key growing therapies and reduce its dependence on anti-malarials. Unlike other pharma companies, it initially targeted Europe and other unregulated markets, before leveraging on its experience in these markets for the US markets, recognising the high risk-reward element in the US markets.

The company earns more than 50 per cent of its export revenues from the European market. As UK is a key market in Europe, which accounts for more than 80 per cent of Ipca's overseas formulation sales, the company recently set up a wholly owned subsidiary in UK.

It has also established subsidiaries in Nigeria and Brazil. Over the years it has developed expertise in manufacturing generics, bulk drugs and intermediates. It has set up subsidiaries in the UK, US and Nigeria and has targeted making new ANDA filings in the coming years, to enhance overseas growth rates.

The company had undertaken a massive restructuring initiative in recent past, setting up separate divisions for therapeutic segments. As a result, contribution from anti-malarials has dropped. But this led to an overall improvement in growth rates, given the focused approach on growing therapies.

The core strategy of the company is three-fold - target the US markets through ANDA filings, strengthen its presence in the existing markets and get into emerging and regulated markets.

To achieve this, the company already has most of its facilities approved by the UK MCA authorities and is upgrading its facility at Ratlam in line with the MCA standards, and expects to commission it by the end of 2005.

For the fiscal ended March 31, 2004, its sales were Rs 633 crore, PBIDT was 20.3 per cent and net profit was Rs 79.3 crore, yielding an EPS of Rs 63.4. For the quarter ended June 30, 2004, sales were Rs 174.4 crore, PBIDT was 14.7 per cent and net profit was Rs 14.7 crore.

NLC is a public sector unit that supplies power to some of the southern state electricity boards (SEBs). Since the company has captive lignite mines, it has the advantage of generating and supplying power to SEBs at cost-effective rates.

NLC received a shot in the arm with the implementation of the securitisation programme by the central government which has started resolving the company's problem of heavy overdues from SEBs.

It has submitted a proposal to the government for expanding its mining capacities at a cost of Rs 5,000 crore (which will hike its tonnage by 6.6 million tonnes) and thermal power station's capacity by 500 mw, and setting up a 250 mw power project in Rajasthan.

Over the past couple of years, NLC has managed to keep its overheads and manpower costs under check by shutting down its loss-making units and offering VRS to its employees.

The corporation, which has been largely been operating with German technology so far, is now looking at alternative mining technologies from American companies. Any hint of divestment could be the icing on the cake for the stock.

For the fiscal ended March 31, 2004, NLC's sales were Rs 2,831.6 crore, PBIDT was 46.6 per cent, net profit was Rs 1,136.1 crore and EPS was Rs 6.6. For the quarter ended June 30, 2004, sales were Rs 656.4 crore, PBIDT was 49.2 per cent and net profit was Rs 198 crore.

HZL dominates domestic reserves of zinc concentrate, the primary raw material for zinc. This helps it control costs. The company was a dominant but flabby PSU for a long time, but things changed after Sterlite acquired it in April 2002.

Its outsourcing move proved effective as it sold 36,000 tonnes more, earning more revenues and increasing its domestic marketshare to nearly 75 per cent, which gave it greater pricing control. HZL became lean and efficient under the new management. It trimmed its workforce over the years. Zinc, like most metals, is generating buoyant demand, thanks to the economic development in China.

But unlike other metals, zinc is better placed to keep its run going even if China's off-take slows as global demand is expected to grow over the next two-three years. In the coming years, the company's cost of production is expected to reduce once its new capacity and a captive power plant are commissioned by early-2005.

For the fiscal ended March 31, 2004, HZL's sales were Rs 1,844.1 crore, PBIDT was 41.7 per cent, net profit was Rs 522 crore and EPS was Rs 12.2. For the quarter ended June 30, 2004, its sales were Rs 421.8 crore, PBIDT was 40.2 per cent and net was Rs 124 crore.

It is a fact that these three stocks have enjoyed their moments of glory at the bourses over the past few months and brought great joy to intrepid investors. But is that enough reason to continue backing them? On the flip side, the stock prices of these companies may have run ahead of their fundamentals.

It boils down to choosing between a large-cap stock that hasn't' lived up to its potential at the bourses and seemingly fully priced mid-cap stocks. Chances are that you will prefer to wait and pouch a large-cap stock at market declines, because, if and when the next party begins at the bourses, the loudest singers will be large-caps.

(The author heads Lotus Knowlwealth, Mumbai, and can be contacted at ceolotus@hotmail.com.
Disclosure: He has no outstanding interest in the companies discussed here.)

Correction: In The Smart Investor issue dated October 18, 2004, we inadvertently said Ashok Kumar has no outstanding interest in the stocks of TCS and ONGC. The correct position is: he has an outstanding interest in both the two scrips. We regret the error.

- Editor