Mid-cap marvels

Small-cap stocks are where the brave go. We get their charm, too. There's the promise of explosive returns and the vivid success stories that play into one's cognitive bias. But what investors, wearing their rose-tinted glasses, forget is that unguarded bravery often exacts a heavy cost. It thus helps to remember that while small caps are often romanticised due to the handful that become multibaggers, the high-fliers are actually few and far between. Couple that with their steep risks like the unproven business models and low liquidity, and the skewed trade-off becomes more apparent. Now, consider their older cousins-the mid caps-who are not only known to fare better during market declines but also for being relatively stable in terms of earnings and market presence. Mid caps are simply safer avatars of small caps. There is the high growth you desire with better odds at success (as explained later in the story) minus the steep downside. The result is a balanced risk-reward proposition. Don't simply take our word for it. Our cover story has packed compelling data points that rule mid caps as the 'goldilocks' bets of the market for risk-adjusted wealth creation. The story also lays out a guide to assist you in spotting promising and fair-valued mid caps in the current market. Towards the end, we have detailed profiles of eight budding mid-caps that merit a place on your research list, given their high-growth potential. Let's begin! Beating odds the mid-cap way: Mid caps have historically shown higher likelihood of healthy gains The highest possible gains are made when companies jump to the upper echelons in the market cap hierarchy. And who leads these gains? Evidently, it is the small caps. Check the 'Predictable progress' graphic. It shows that small caps generate the most lucrative returns when they migrate to a category above them. For instance, a small-cap stock generates an average return of 50 per cent on becoming a large-cap bigwig. Compare this with our contenders-the mid caps-which only generate 28 per cent on average on joining the large-cap cohort. Quite an underperformance, right? Not when you consider the success rate of the migration. A small-cap turning into a large-cap is a rare occurrence with a probability of below 1 per cent! That means only one out of eight small-cap stocks manage to make it big. So getting that 50 per cent return is a pipedream at best. Meanwhile, more mid caps rise through the ranks than their smaller counterparts. An average of 24 per cent, or around one out of four mid-cap stocks manage to migrate and succeed in becoming large caps. So, there's no two ways about it. It is wiser to stick with a safer, smaller reward than to gamble on a bigger gain that's far less likely to be realised. Why the better odds We have concluded that mid caps demonstrate a higher probability of evolving into big heavyweights than small caps do. But what makes the former's odds better? One factor is their size. Those who seek sizable returns usually avoid large caps, simply because they are too big to compound money at a high pace. On the other end are the small caps, which boast ample legroom for aggressive growth, but are often pushed to the wall by bigger competitors. Mid caps, however, are able to hold fort against competitors. At the same time, their size allows them to be aggressive compounders. Many mid-cap companies, especially those that are managed right, also hold strong positions, or market leadership in their respective industries. TVS Motors is an apt example. In its mid-cap avatar, the company was by no means a market leader in 2019. But it wasn't too small either to be easily knocked out by bigger players. Its size enabled it to keep gunning out solid earnings growth with consistent new launches, and it eventually yielded a five-year annualised return of 47 per cent! Strong defenders Mid caps put up strong defence against high volatility, compared to small caps, which improves their appeal as safer bets. If we compare the losers, an average of 36 per cent of mid caps have generated negative returns in the last five years. This number, though, increases to 42 per cent in case of small caps, showing the higher incidence of losses. Moreover, as seen in 'Safer, higher, better!' graph, the five-year median returns of mid caps have almost always been higher against those of small caps. Not just that, at the index level too, the BSE Midcap has outperformed its small cap peer nearly 60 per cent of the time in the last 16 years (based on monthly five-year rolling returns between July 2009-July 2024). Evidently, fortune doesn't always favour the bold. At least that's what history suggests. Bedrocks for building wealth: Parameters essential to spot high-potential mid caps Mid caps are hands down winners for those favouring a level-headed approach to building wealth over diving headfirst into the daring and much less certain world of small caps. The next step is to identify mid caps capable of generating outsized gains by moving up the market cap ladder. But the quest for such candidates involves evaluating four key pillars fundamental to wealth creation across all stocks, not just mid caps. These are growth, quality, leadership, and valuation. Here's why they should be at the top of your investing checklist: Growth: This one is a no-brainer. Look for companies that have proved their mettle with a healthy growth report card. They are more likely to build you a buffer. History is a testament to this. Companies whose annualised profit after tax grew over 10 per cent in the last decade have generated around 20 per cent annual returns on average over the same stretch. On the other hand, companies whose annual profit after tax grew less than 10 per cent over the last decade could only generate a median annual return of 10 per cent during this period. Evidently, higher growth rates lead to higher outperformance. Quality: Growth, no matter how solid, is only half as impressive if it's not supported by a robust return on capital (ROCE). Let's take an example to demonstrate this. Company A and B start operations with a capital of Rs 1,000 each and a cost of capital of 11 per cent. Company A clocks a 7 per cent ROCE, below the 11 per cent cost of capital, which results in erosion of its capital value by 14 per cent to Rs 865 in five years. Check 'Why quality matters' graphic. B, on the other hand, sees its

This article was originally published on September 01, 2024.