Is it time to make that tactical allocation back to midcaps?

Before Sebi came up with the market-cap categorisation guidelines in order to ensure uniformity with respect to the investment universe of equity mutual fund schemes, the generally accepted norm for a midcap company was that of a market capitalisation range between Rs 5,000 crore and Rs 20,000 crore.

As per the Sebi definition of October 2017, midcaps are companies ranging from those from No 101 to 250 in terms of market capitalisation.

One of the most distinguished characteristic of companies in this segment is higher growth rates compared with their larger peers. Investors have always flocked to this category of stocks in anticipation of higher returns given their potential to report increased profitability and market share gains.

Why Midcaps? Improving GDP growth has always benefitted them
The Nifty Midcap100 index shows a very high correlation with GDP growth. As such, midcaps tend to outperform Nifty50 in high growth phases and tend to underperform in low growth environments.



Why Midcaps? Some sectors can be played exclusively through midcaps
It is important to examine the sectoral weight of Nifty50 versus the NSE MidCap100 index. Auto and auto components (cyclical revival + personal mobility), consumer (pent-up + improving sentiments), real estate (low interest rates), chemicals and pharma (China + Atmanirbhar Bharat) and utilities (cyclical) have structural tailwinds favouring them with consensus positive outlook for the next 18-24 months.


Each of these sectors have low presence in Nifty50 and are better represented in the listed universe through midcaps.

Why now? Low interest rate regimes have favored midcaps in the past

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Growth-hungry midcaps flourish in low interest rate regimes. Data shows a high correlation between the repo rate and the ratio of Midcap index to Nifty50 since 2002 – again suggesting a likelihood of outperformance over Nifty in the coming year/s, if interest rates continue to remain low.

In conclusion: With the unprecedented events behind us, the next one or two years may well belong to midcaps.
Since January 2018, there has been massive P/E multiple de-rating in midcaps and smallcaps. We can say this with the benefit of hindsight as no one would have predicted the series of issues that would crop up from 2018 till date.

A combination of

• three consecutive years of declining GDP growth rates
• crippling regulations like demonetization and GST
• NBFC crisis
• real estate crises post RERA, and
• Lastly, the global Covid pandemic has created a deluge of bad news for these companies.

Never in the history have smaller companies been through stressful times than in last three years. Their business models were not wired to handle such simultaneous attacks. In the meantime, the larger players have benefitted. This has rightly so reflected in consecutive years of underperformance vis-à-vis largecaps.

But is this changing?
The current disruption has forced them to rework their business models right from sourcing to manufacturing to distribution. Many smaller companies have adapted and embarked on prudent cost-cutting measures and cleaned up their balance sheets by reducing debt.

Interest rate cuts and the likelihood of a low interest rate regime has come as a welcome news for midcap stocks.

Investor apathy for midcaps since January 18 has seen signs of reversal. FII flows getting further broadbased is likely to see buying preference coming back to midcaps.

The return of earnings growth may well be the last validation. However since markets are forward looking, it may well be prudent to enter early.

(Umang Thaker is Head of Products at Motilal Oswal Mutual Fund. Views are his own)