Investment tip: How to choose the best mid-caps to invest in

There is a perception that mid-cap stocks are risky. This is partly right, as some risks are directly related to size. One more reason is that mid-caps are under-researched and, therefore, more likely to be priced wrongly. Investors, however, can benefit from this by identifying potential winners early.

"The combination of strong earnings growth and possibility of valuation re-rating make mid-caps clear winners," says S Krishnakumar, head, equity, Sundaram Mutual Fund.

"Mid-caps outperform largecaps when the economy is reviving," says Dipak Acharya, fund manager, equity, Baroda Pioneer AMC.

With corporate earnings bottoming out, experts say it's the right time to invest in mid-caps.

"There is a perception that investing in mid-caps increases portfolio risk. That is why many people are reluctant to invest big amounts in these stocks," says Tushar Pendharkar, senior analyst, Right Horizons. "But we believe that this difference between largecaps and mid-caps will vanish in 2014." He says this is because increasing opportunities and consolidation have added a lot of value to fundamentally-sound mid-cap companies.

Pendharkar gives the example of PVR, which he says has got the benefit of improved Bollywood content as well as change in the attitude of Indians towards movies. Another example, he says, is Amara Raja Batteries, which has fast emerged as the second-largest player in automotive and industrial batteries.

INVESTING CHALLENGES

Only a few mid-caps are tracked by brokerages and research houses. So, there is a shortage of information about these companies in public domain. This makes investing in them risky. "You must do a lot of research before investing in midcaps. The risk of failure is higher in smaller companies, unlike the big ones, which have gone through the learning cycle and/or have the backing of strong parents," says Krishnakumar of Sundaram Mutual.

"The most important factor one should be mindful of while investing in mid-cap companies is management quality," says Acharya of Baroda Pioneer AMC.

Since large-cap companies have a long history of in-depth coverage by research and brokerage houses, investors can be more confident about the quality of their managements. "But in the mid-cap space we have to ensure that the company has the management bandwidth to take the company to the next level," says Acharya.

However, Neelesh Surana, head, equity, Mirae Asset Global Investments (India), says the basic principles of investing are the same for both large-caps and mid-caps. He says one must never lose sight of three things-business characteristics, management quality and valuation.

"However, as mid-cap companies are generally underresearched, there is need for stricter due diligence on the first two factors. Also, regarding valuation, it is prudent to have a higher margin on safety given the additional risks involved."

EXPECTATION 2014

The valuation gap between largecap and mid-cap stocks has been increasing for the last few quarters. "Market volatility has kept midcaps under pressure," says Pendharkar of Right Horizons.

But a few mid-cap companies such as Amara Raja Batteries, Vardhman Textiles, Cadila Healthcare, Cummins India, Tech Mahindra and AIA Engineering have grown very fast in the past couple of months. These, say experts, can be good bets.

Surana of Mirae Assets says the CNX Midcap index is trading at a discount, both to its own longterm average and the Nifty. For example, the price-to-book value discount compared to the 10-year average is about 35%.

"This is understandable as mid-cap and small-cap companies have seen sharp earning downgrades. Plus, economic slowdown and high interest rates are pinching them harder," he says.

V Balasubramanian, vice president & fund manager, IDBI MF, has a slightly different view. "Valuation does not depend upon the market cap. In fact, it is a function of the stock price and the number of shares." He says some mid-caps trade at a premium to large-caps. "A stock, irrespective of whether it is a large-cap or a small-cap, can be bought as long as it is backed by growth and strong fundamentals. Investment decisions need not depend upon market caps."

"Today's mid-caps could be tomorrow's large-caps. Whenever the economy revives, mid-caps outperform large-caps. Not only do they deliver better earnings growth, they are also re-rated. Such a multiplier effect generates significant alpha in the portfolio," says Acharya.

Raghu Kumar, co-founder, RKSV, a brokerage, says, "Foreign institutional investors will not hesitate to invest in midcaps with good long-term potential as they are cheaper and have higher potential to reward investors. Hence, the participation of institutional investors in a stock is a plus."

LIVING WITH VOLATILITY

Experts say volatility is inevitable in mid-caps. But a sound investing strategy and bottom-up stock-picking can take care of these concerns.

"One should invest in mid-caps with a long-term view of three-five years to realise the full benefit of embedded growth and value creation. Volatility is a friend of longterm investors, as it helps them buy at lower price points," says Krishnakumar of Sundaram Mutual.

Surana of Mirae says investors should focus on quality businesses as growth mitigates many risks. Plus, they should go for a sound asset allocation so that the equity portfolio and risks are spread out among large and small companies.

Another reason for the volatility in mid-cap stocks is fewer shares. "It doesn't mean that all mid-cap stocks are risky. Investors should have a long-term horizon to avoid panic during volatility," says Pendharkar of Right Horizons.

EXITING MID-CAP

The biggest issue with investing in stocks is deciding when to exit. And considering that mid-cap stocks are highly volatile, having an exit strategy is a must. Most times investors enter at peak valuations. Even if they buy at the right time, it is difficult to decide when to sell.

"Near bull-market peaks, smallcaps and mid-caps trade at a significant premium to large-caps as investors' high risk appetite creates a bubble," says Krishnakumar of Sundaram Mutual Fund. This is the right time to exit. "Another approach is catching the slowing growth in revenues/earnings as companies grow in size and show inability to outpace competition".

Surana says one must follow a well-crafted asset allocation strategy. "If the allocation to mid-caps is, say, 30%, it should not be altered beyond a band."

Kumar of RKSV says investors should manage their exposure to mid-caps through proper risk management.