While the benchmark Sensex delivered returns of 26 per cent in 2012, the BSE Midcap Index has done better with returns of 38.5 per cent. A large part of this rally in the mid-cap space came across in the last quarter of 2012 - fuelled by the announcement of a bunch of reforms.
Notably, the valuation gap between both the indices had increased over the past few years due to three key macro-economic worries moderating GDP growth, weaker rupee and high interest rates. The BSE Midcap Index now trades at a one-year forward price/earnings (P/E) ratio of 11.7 times or 19.3 per cent discount to the BSE Sensex P/E of 14.5 times. Historically, the BSE Midcap Index has traded at an average forward P/E ratio of 14.3 times (see chart). However, experts believe, these metrics are likely to turn favorable for the mid-caps in 2013.
"We expect the divergence between BSE Midcap Index and BSE Sensex to narrow over the next couple of years. Earnings growth for BSE Midcap Index for FY13/FY14 at 25/26 per cent is significantly higher than the estimates for BSE Sensex at 6.8/15.8 per cent, which bodes positively for mid-cap stocks," leading brokerage Motilal Oswal Securities wrote in a recent report.
Expectations of improving GDP growth, stronger rupee as well as peaking out of interest rates will rub-off positively on the mid-cap sector. Historically, mid-cap stocks have outperformed their larger peers in times of higher growth in gross domestic product. Analysts expect this trend to continue in 2013 as well.
"We have strong visibility of recovery in the first half of 2013. Cyclical economic recovery as well as easing rate cycle will help mid-caps to outperform. The second half though, will be a pre-election phase and could bring some uncertainty in the markets. While we expect better earnings quality for mid-caps, a significant re-rating of valuation multiples will warrant a much stronger economic recovery," says Gautam Chhaochharia, head of India small/mid-cap research, UBS Securities.
Tirthankar Patnaik, India strategist and economist, Religare Capital Markets echoes this view. He says, "We expect the out-performance of mid-cap stocks to continue in the first half of 2013, not beyond that, as the market will start looking at real deliveries by then." While the announcement of any unfavorable measures by the government in the pre-election phase remains a key risk, continuation of the reforms process will act as key catalyst going forward.
Identifying good investments
However, given that Indian mid-cap sector composition is large, diversified across many sectors and there is low liquidity in some scrips, one has to follow prudent strategy while investing in this space. Factors such as management quality, high return ratios and strong growth prospects of earnings and cash-flow should be weighed against the prevailing valuations to identify a favorable risk-reward scenario. "One approach to investing in mid-cap stocks is to focus on leaders in relatively small but growth sectors. The overall growth in the sector, increasing market share due to their relatively dominant position, margin benefits on increasing scale and expansion of valuation multiples can be significant stock price drivers," says Anantha Narayan, research analyst at Credit Suisse.
Thus, stocks such as Dish TV, MCX, Info Edge, McLeod, Cox & Kings, Kajaria Ceramics, Concor, Apollo Hospitals, CRISIL, Bata, United Phosphorous, TTK, DB Corp and Raymond appear to be well-poised to gain from the long-term growth story of their respective sectors.
The strategy of bottom-fishing (stocks that are beaten down significantly) can also be used to identify companies based on strong potential for future growth. However, this strategy can prove risky if the assumption of turnaround in the company is inaccurate. One can also look at companies focussing on de-leveraging their balance sheets by monetising their non-core assets.
"With the government focused on kick-starting the capex cycle and improving the business environment, coupled with a likely softening of interest rates, we prefer companies with robust business models that are present in under-penetrated markets or that have exposure to an improving business environment," believe Harshad Katkar and Amit Murarka, research analysts at Deutsche Bank.
Most analysts remain bullish on the media sector - given the successful implementation of the digitisation process which will improve these companies' financial performance significantly. Notably, stocks such as Den and Hathway have run up significantly in 2012 and could witness only marginal gains from current levels. Others, such as Dish TV, remains a top pick of most brokerages.
Analysts also like the mid-cap bank scrips such as Bank of India and Karur Vysya Bank, which could gain from economic recovery (lower non-performing assets) and falling interest rates (higher credit offtake).
Mid-cap cement scrips such as JK Lakshmi Cement are also amongst the preferred picks of most brokerages and are likely to gain from the strong prospects of the cement sector, going forward.
Further, stocks such as Financial Technologies and Tech Mahindra also offer significant upsides from current levels, believe analysts.
Brokerages prefer avoiding stocks in the mid-cap real estate and infrastructure sectors. Consumption stocks such as Jubilant Foodworks are trading at rich valuations and will be under pressure as more and more investors move towards cyclical sectors.