Midcap celebrations

With a big rally taking it to all-time highs, the NSE Midcap 200 index has been the focus of attention in the stockmarket in recent weeks.

At a time when it was widely assumed that there was little steam left in the market, the pace of the rise has raised eyebrows, with many market participants urging investors to be cautious.

The rise has been across the board, and that is always a warning sign. Moreover, it's not only midcap stocks that have done well; even small-caps (stocks with a market capitalisation of less than Rs 75 crore by the NSE's definition) have handsomely outperformed the Nifty.
The surge in penny stocks, in particular, is a matter of concern. Clearly, operators are making the most of the fact that a little money invested in relatively illiquid stocks sends them a long way up.

One reason for the outperformance of the midcaps is, therefore, clear: the same amount of money invested in large stocks wouldn't have had the same startling effect.

Other reasons adduced by the market include the lowering of the short-term capital gains tax in this year's Union Budget. Market analysts point out that it is roughly around the time of the Budget that the NSE's Midcap index started outperforming the Nifty.

However, the fact is the NSE Midcap index was outperforming the Nifty even in last year's boom. So there are clearly more fundamental factors also at work. What are they?

Some of the sectors that have a strong investment theme have many small companies.

This is true of the sugar sector, for example, where a demand-supply mismatch has driven share prices up, and of the textile sector, where the scrapping of the multi-fibre arrangement by January 2005 is expected to benefit Indian textile companies.

It's also true of the IT segment or auto ancillary companies. In short, it's not only large Indian companies that have growth stories attached to them. Another reason for the rally in smaller company stocks is the fact that many of them have restructured their operations, emerging as leaner, more competitive, entities.

Obviously, that would call for a re-rating by the market, which is exactly what has happened. Yet another reason for the rally is the interest taken by foreign institutional investors in midcap stocks.

The figures show that FII holdings in midcap stocks have risen substantially. And lastly, of course, there's the attraction of value, since midcaps usually have lower price-earnings ratios than large-cap stocks.

That said, however, there are ample reasons for investors to be cautious. For starters, the P/E multiple of the Midcap index is now higher than that of the Nifty, which is unusual, given that institutional money prefers to invest in liquid scrips.

In short, while there will always be good stocks that offer value, investors should be wary of indiscriminately climbing aboard the midcap bandwagon at this stage.