It is almost an axiom that mid-caps and small-caps will outperform big stocks during a bull run. It is also true that smaller stocks get beaten down more than big stocks during bear markets. We have certainly seen this phenomenon of outperformance by small stocks over the past six months. The CNX Midcaps has risen 34 per cent since January 2014 versus a 19 per cent rise for the Nifty.
If the acche din slogan is based in reality, this trend of outperformance by smaller stocks should continue as an economic recovery starts and gets stronger. The recovery should lead to a revival of the capital expenditure and investment cycle.
What is more, it could be the sectors which have been hit hardest in the recession that now yield the best returns. For example, there should be a recovery in demand for trucks and commercial vehicles if there is a broad economic recovery.
Automobiles have seen contraction in unit sales volume over the past two years. This industry has an especially long and broad value-chain with multiple employment opportunities for people with different skills. This implies that any volume recovery in automobiles will automatically lead to improved prospects for many other industries starting with auto-ancillaries and transport financing.
Also, given the new government appears determined to clear and expedite stuck infrastructure projects, infra developers and financiers should see improvement in their prospects. Again, infrastructure covers a broad area and offers employment to a labour force with many different skills. It is also capital-intensive. So if there is movement on the project front, infra-financiers should see improved bottomlines and so should construction companies and manufacturers of materials like cement and steel.
In all these spaces, mid-cap and small-cap players are more likely to see sharp improvement and there has already been some institutional action from foreign institutional players (FIIs), based on the logical extrapolation of such themes. FII ownership of midcaps (meaning stocks in the CNX Midcaps and BSE Midcaps) is hovering near all-time highs.
Changes in Shareholdings are available only at the end of each quarter. At end-March 2014, FIIs owned around 14 per cent of the midcap index. There has been heavy FII buying through April-June and some of this has undoubtedly gone into midcaps.
Mid-caps also have room for steeper uptrends because the price corrections in smaller stocks were more in the last bear market. Despite the strong index performance of the past few months many individual midcaps had been beaten down so badly that they are way below their respective all-time highs. This is in contrast to the Nifty/Sensex constituents, which are mostly trading close to their all-time highs.
The investor/trader could reasonably hope for a phase where the midcaps see accelerated uptrends until they approach closer to all time highs and catch up. This impression is reinforced by the valuations - mid-caps are relatively speaking, undervalued in comparison to large-caps in similar areas of business. For example, large-cap pharma stocks are, on average, trading at current PEs of 44-plus. Smaller pharma stocks are trading at around 29-30 PE.
Admittedly, larger stocks have more stable financials than midcaps in the same industry groups. This is one of the major reasons why mid-cap performance is worse than large-caps during recessions and better during upticks. Mid-caps are more highly leveraged and tend to have lower Ebitda margins as well. If interest rates do fall, they tend to see sharper improvement in financial performance.
Interest rate trends will probably be crucial to any economic recovery however. Rates are unlikely to move down in the short term or medium term. The poor monsoon has more or less ruled out the chances of an immediate rate cut.
However rates have probably peaked. As and when rates do move down, banking and non-banking financial companies will probably zoom. So will housing finance companies since lower rates would drive demand.
Assuming that this story of economic revival driving strong mid-cap performance with falling interest rates turns out to be true, the multi-baggers are most likely to be found along the value chains associated with the automobile and infra sectors.
