Many investors have flocked to mid-cap stocks over the last 12-18 months and they have not been disappointed, with the S&P BSE MidCap index delivering 48% returns in the calendar year 2017. Individual mid-cap stocks have gone up 2-3 times in the same period, while S&P BSE Sensex (large-cap) has delivered around 28%. Typically, return expected from a mid-cap stock is higher than that of its large-cap peer in the same industry, as the earnings growth of the former is projected to be steeper. But have you wondered how a mid-cap stock is defined, how to identify it and why these stocks deliver higher return multiple?
Defining a mid-cap
Till now, every fund manager one spoke to had a different market capitalisation range to define mid-cap stocks. Now however, with the Securities and Exchange Board of India’s (Sebi) latest guidelines on categorisation of mutual fund schemes, the mid-cap segment is defined as the basket that contains the 101st stock ranked by market capitalisation to the 250th stock.
According to Mittul Kalawadia, fund manager, ICICI Prudential Asset Management Co. Ltd: "At ICICI Prudential AMC, we have always been using market capitalisation as a starting point. It is a globally recognised methodology of determining whether a stock is mid-cap or not.”
Metrics like balance sheet size, revenues or profits are not commonly used because despite, say, large revenues, a stock may be valued low in the market if it is delivering successive years of losses. According to Vikas Gupta, chief executive officer and chief strategist, OmniScience Capital, an investment management firm: “Despite amazing sales without profitability, the collective wisdom of the market doesn't value as being worth much and it could fall to the micro-cap category. Using market capitalisation creates uniformity in selection.”
But do these stocks conform to particular trends in terms of profits, balance sheet particulars and so on? Why are mid caps riskier?
“While in large-caps we expect a stable, predictable revenue and profit growth, mid-caps have the ability to stretch that pace of growth. It is the phase of super performance that is flanked by reasonable performance in terms of revenue and earnings growth that defines a mid-cap stock. To grow at this supernormal pace, companies take operational risks which, if not managed well, can end up losing market value,” said Shyam Sekhar, founder and chief ideator, iThought, an investment advisory firm.
In the current market where many investors are chasing mid-cap stocks, there is even more reason to be careful as not all bets will evolve profitably, Sekhar warned.
Mid-caps can be new or well-established companies. What they have in common is the phase of supernormal revenue and profit growth. What makes these companies an exciting investment opportunity is their ability to generate above-average profit growth for a foreseeable period. However, given the risk of failure, mid-cap stock selection needs careful attention.
According to Soumendra Nath Lahiri, chief investment officer, L&T Investment Management Ltd, “Mid-cap stocks are usually under-researched, under-owned and under-valued. While the index P-E (price-to-earning ratio) could be high, individual portfolios don’t always have high P-E stocks. In mid-caps, you need to buy stocks where you understand there is potential to grow. If you can get growth, then valuation is not a big concern. Understanding promoters and their operation risk is important."
The 100th stock by market capitalisation today has a value of around Rs30,000 crore while the 250th stock is roughly Rs9,500 crore. In a bull market, this range is likely to start from a relatively higher base than in a bear market. While the market capitalisation range for mid-caps keeps getting adjusted, their characteristics don’t.
Homogeneity in funds
With Sebi’s new definition for mid-cap funds, all funds will have to conform to the defined range for mid-cap stock selection.
Gupta said, “The move brings uniformity, which makes things clear. Usually people will talk about a liquid and reasonably largish stock as mid-cap but it may really be a small-cap in technical terms.”
The flip side is that there is likely to be some restriction in terms of stock selection.
Kalawadia said, “Post the categorisation clarification, the selection universe for a mid-cap fund is restricted. There will be homogeneity and large swings in alpha among funds will be restricted."
Till now, despite benchmarks, there was a degree of discretion with the fund managers in how they picked stocks for their mid-cap funds. Some argue that limiting the stocks that can comprise mid-cap funds, would limit their ability to generate their characteristic alpha. However, there is some leeway here as only 65% of a mid-cap fund is to be from the Sebi-defined segment. For alpha, a greater effort in large- or small-cap stock selection for the remaining 35% of the portfolio may be required.
Sekhar says, “Given that the velocity of inflows to buy mid-caps directly or via funds is uncontrollable, categorisation reduces the space to deploy money. Compulsion to invest could create a...stampede, people will buy the same stock thus, impacting price. But this is not fundamental, it’s a technical issue that can affect price.”
Not only will funds use the same basket to select stocks, it is likely that they will use a common benchmark too rather than the variety we see currently. Index providers have been quick to respond and build appropriate indices to cover the categories as defined by Sebi.
“According to Mahavir Kaswa, senior manager, product management, S&P BSE Indices, “There have been multiple ways to identify large-, mid- and small-cap stocks, however SEBI guidelines have streamlined this. In order to ensure we have indices that align to the SEBI guidelines, we launched a new set of size indices to cater to the need that will arise from benchmark users. The benchmarks are available with back-tested history of 10-12 years of data.”
NSE has also launched new indices to cater to the changed definition of mid-caps.
If you are keen to invest in mid-caps, keep in mind that these present an opportunity to benefit from an above-average growth in profits. This happens as the company grows its revenues, balance sheet and market share. If this trend continues, the company can becomes a large-cap stock too as the market begins to price its stock at a premium. If the company fails to scale up profitably, it can also slip into the small-cap space.
Here in lies the risk in mid-caps, stock selection is key. If you are not confident about your ability to envisage the journey of a mid-cap stock towards becoming a large-cap, it is best to leave it to fund managers who spend time understanding such opportunities in depth. You have to spend time and effort in choosing a good mid-cap fund.