Midcap stocks on a roll but tread carefully

Tags: Stock Market
Midcap stocks on a roll but tread carefully
Midcap stocks are leading the ongoing rally, just as in election years 2004 and 2009. While the Sensex had rallied 81.03 per cent in 2009, the BSE midcap index surged in triple digits (107.66 per cent) during the same year.

In 2004 too, the returns offered by the BSE midcap index at 25.53 per cent was much higher than 13 per cent offered by the BSE Sensex.

However, to see enormous gains this time, clear signals on economic recovery rather than just election outcome are required. It is generally seen that midcap stocks outperform largecap benchmarks whenever the growth momentum sets in, and vice-versa.

Asked to compare election years, Pankaj Pandey, head of research at ICICI Securities, believes that 2009 was quite different from 2014. “If we look at previous election years, the economy was in good shape with GDP growing at a healthy pace of around 7-9 per cent. This time, none of the economic indicators is heartening so far. Inflation has remained high for the last two years and factory output growth has been muted. It would be difficult for midcaps to show similar returns of 2009 this time,” he said.

A total of 227 constituents from BSE midcap index have reported 16.72 per cent YOY fall in combined net profit on 7.86 per cent YoY modest rise in net sales for the nine-month ended December 31, 2013.

So while it is too much to expect midcaps to gain in triple digits in 2014, they can still perform well this year in case economy improves.

If we look at the four-year period FY04 and FY07 (when GDP growth stood between 7 per cent and 9.20 per cent), the BSE Sensex witnessed a CAGR growth of 43.90 per cent. The BSE midcap index, on the other hand, witnessed a higher CAGR growth of 54.21 per cent during the same period.

From 9.20 per cent in FY07, GDP growth declined to 6.9 per cent in FY09. During this period, the BSE midcap index gave a negative CAGR of 25.90 per cent against 13.82 per cent negative CAGR by Sensex.

The next two years saw economy recovering to 8.9 per cent in FY11, but a bad phase remerged.

GDP growth fell to 6.7 per cent in FY12 and 4.5 per cent in FY13. Sensex clocked a negative 1.58 per cent CAGR during this period compared with a negative 5.47 per cent CAGR of BSE midcap index.

The BSE midcap index is up 40 per cent since August 28, 2013, compared Sensex’ 25 per cent. This financial year (FY15), the BSE midcap index has already climbed 3.62 per cent (9.45 per cent YTD) against 1 per cent (6.89 per cent YTD) rise in the Sensex.

“The reason for this outperformance so far is inflow of domestic money into small and midcap companies. Earlier the index was largely led by FII inflow in top 80 companies in India. But lately, led by improving market sentiments, we have seen new money flowing into such counters. There is a proven history that midcaps and smallcaps are always the late entrant in a rally,” said Vinod Nair of Geojit BNP Paribas.

Out of 159 midcap firms that have announced shareholding pattern so far, 112 of them have seen their stock prices giving positive returns. A total of 28 of these stocks climbed between 25 per cent and 65 per cent; 69 climbed more than 10 per cent. Ravi Shenoy, AVP for midcaps at Motilal Oswal Financial Services, believes it is common that whenever an event with long-term implications comes, the market tends to factor in a growth story for the next 2-3 years in advance.

“We believe the ongoing rally is purely a hope rally. The midcaps that have rallied so far are of those firms where either debt levels are high or are highly pledged. If an investor knows how to pick the right midcap stock, he should be looking to stay in that counter for at least two years,” Shenoy said.

The International Monetary Fund (IMF) recently pegged India’s GDP at 5.4 per cent in 2014 citing slightly stronger global growth, improving export competitiveness and implementation of recently approved investment projects.

However, downside risks prevail. GDP growth has so far remained at sub-5 per cent level, factory output has been in red and a falling inflation trend has just reversed.

“We advise clients to focus on the IMD's first monsoon forecast. If El Niño occurs by summer, it will drive rain clouds away. If it stretches to the fall, India will mercifully escape. We remain concerned that this could hurt FY15 growth by 50-75bp, especially if the RBI delays rate cuts due to rising agflation/inflation,” said Indranil Sen Gupta of BofA-Merrill Lynch.

“Many small- and mid-sized companies have maintained their niche market dominance. They have streamlined balancesheet and operational efficiencies and are well placed to experience a re-rate in valuation. But for this to happen the large caps will have to get further re-rated, i.e., the index also has to performer well,” Nair says. One can also look at whether the promoters shown interest in increasing their stakes in the firm.

Pandey’s advice is on similar lines. “Buying in midcap and smallcap stocks should be a bottom-up exercise. There is no single parameter investors should look at in isolation before investing. But a firm with low cash requirement or a business model that requires cash once in a long period could be preferable. Investors can look at enterprise value (EV) multiples in case of capital-intensive firms in the same industry,” he says.

Midcaps remain takeover targets and EV multiples or EV/Ebitda is a measure widely used to evaluate the company’s worth.

EV adds debt, minority interest and preferred shares, minus total cash and cash equivalents to the prevailing market capitalisation. This is due to the fact that when a company is bought, new owners are required to bear debt burden. They also factor in non-operating cash levels of the firm.

Even if a firm is not a takeover target, EV/Ebitda is useful as when interest rates fall, debt also falls and operating profit and cash rises, which reduces EV/Ebitda value, indicating the firm might be undervalued.

Shenoy says EV multiples is a good method for cases such as Jaiprakash Associates, as when falling interest rate cycle begins, debt portion with shift towards equity.

“We also advise investors to look at pledged shares, stock deliverables (as there can be speculative buyers driving the stock), earnings, margins as well as dividend record,” he says. zz

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