When small is probably better

Last Updated: Mon, Sep 23, 2013 03:04 hrs

If you go by conventional wisdom, stocks of mid-cap companies should outpace the large-cap firms in the long run. Yet, in the past three years, the BSE's mid- and small-cap indices have lost 27 and 46 per cent, respectively. By contrast, the large-cap BSE Sensex index gained a sturdy 11 per cent. Small- and mid-cap companies lost close to 51 per cent in market capitalisation, while the Sensex gained 6.5 per cent in the past three years.

Investors have been shunning small- and mid-caps to such an extent that their valuations have taken a huge beating. Three years ago, the BSE mid-cap index was trading at a price-earning multiple (PE) of 20. Today, its PE is around seven, nearly 65 per cent lower. On the other hand, the valuation of the Sensex has been steady at around 15 to 18 times PE for the last three years. Why has there been such a carnage in the mid-cap space? Should investors now search for value here?

Market experts say Sensex companies are safer as most of them have earnings from abroad. Investors have been focusing on these companies due to their dominant balance sheets and higher foreign exchange earnings. On the flip side, mid- and small-cap stocks are lumbering in their revenue and profit growth in a slowdown.

Says G Chokalingam, managing director, Centrum Wealth Management: "The Sensex has many companies that earn foreign exchange, which are doing well. The mid- and small-cap space is largely dominated by companies that earn rupee revenues which has been going through a slowdown. Therefore, there's a divergence in their indices."

Small- and mid-cap stocks have also been hit by issues such as higher promoter pledging and poorer corporate governance. Besides, some of these companies have heavily leveraged balance sheets, impinging their ability to repay loans and expand. Says Mehraboon Irani, head, private client group, Nirmal Bang: "One in four companies will have a debt problem. Investors will have to be very careful and watch for companies that are overleveraged or their promoters have pledged shares."

But the mid-cap space is not all about gloom and doom. A host of companies here have made some handsome returns for investors the past year. For instance, Ajanta Pharma rose 154 per cent last year, whereas Alembic Pharma surged 95 per cent. If you think these are foreign exchange earners, even stocks of companies catering to the domestic market such as Kaveri Seed and Amara Raja Batteries surged 62 and 57 per cent, respectively.

Experts say finding the right mid-cap stocks requires that one keep a close eye on cash flows and patience for these stocks to deliver returns. Says Irani: "Mid-cap stocks will follow the large-caps one day but investors will have to be highly selective in choosing mid-cap stocks."

Investors should look for companies that can navigate the slowdown by reducing debt or cutting costs, and those that can grow their bottomlines. Says Chokalingam: "Investors must always look at earnings potential of a company in a slowing environment. Earnings growth of small-cap and mid-cap companies have been lower than expected and, hence, some of these are seeing a sell-off. But the valuations of some of these stocks are looking attractive."

A recent study by CRISIL showed mid-caps generate higher returns with a lower volatility, as compared to large-caps. The CNX mid-cap index returned a 23 per cent annualised return over a 10-year period, as compared to 19 per cent for the CNX Nifty. The study also showed the mid-cap index was far more diversified, with 23 per cent allocation to defensive sectors, as compared to 10 per cent in the Nifty. Among the key factors to look for attractive companies in the mid-cap space are a high return on equity. Profits are not the ultimate way to measure a company. Return on equity measures how much it earns, relative to what the shareholders have in the business. The higher the return on equity for longer periods of time, the better the chances of the company rewarding its shareholders. Says Bharat Shah, executive director, ASK Wealth Advisors: "Ultimately, it's the return on capital that an investor should look for and whether that company is a small and mid-cap does not matter."

Another thing to look for is steady dividends. Companies that routinely pay at least up to 10 per cent of their profits as dividends generate a healthy amount of cash in their balance sheets. Even if these companies are not high dividend payers, they can use the excess cash to expand their business and generate higher amounts of return on equity. Experts say in looking for quality in small and mid-sized companies, a dividend-paying ability comes first.

And, there are growth prospects. You want to be certain a company can continue to earn strongly in the future and, therefore, you should see whether it has a strong competitive advantage. Even small companies can have some, either in the form of a niche product, used as an input that very few people can manufacture, or it can be a niche brand.

There are quite a few companies in the small-cap and mid-cap space that can generate strong cash flows and have a good, sustainable, competitive advantage. Not all small-cap and mid-cap companies are poised to reward shareholders; some might even fall before recovering. But, over time, as these companies generate more shareholder returns, the stock market should reward investors slowly over time. Investors may have to wait for some time for the market to recognise the true potential of these stocks. But once that happens, the returns could be huge. Market watchers say mid-cap stocks are at compelling valuations now. At these low valuations and with careful stock selection, you can start to accumulate a few mid-cap stocks at these distress sale prices, say experts.

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