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Mid-caps: is it a case of too much of a good thing?

In every market rally emerges an underlying theme where outperformance vis-a-vis the broad market is marked and at times spectacular

Mid-caps: is it a case of too much of a good thing?

All market rallies can be identified by a narrower theme that outperforms the broader market's upward movement. The current market rally, which commenced in August 2013, can be characterised by the outperformance of mid- and small-cap companies over the broader market uptick. As the adage goes "all good things must come to an end", are the mid- and small-caps in danger of becoming victim of their own success?

The Greek hero Odysseus (who designed the Trojan horse in the war against Troy) wanted to come back home to the island of Ithaca. He could take a longer sea route or a more treacherous shorter route. He chose the latter, and had to pass through the treacherous waters off the coast of Capri, where the Sirens would allure sailors with their singing and music, leading to ships wrecking and drowning. Odysseus, aware of these "fatal attractions", had his men's ears plugged with wax and himself bound to the mast. Do investors have a similar plan to avoid the alluring charms of the mid- and small-cap segment?

In every market rally emerges an underlying theme where outperformance vis-a-vis the broad market is marked and at times spectacular. Over time, the market phase is characterised by the theme that drove the markets. The 1999-2000 rally, for example, is viewed as an ICE (information, communication, entertainment) driven rally, which iced investors in its aftermath. While the 2004-08 rally was across sectors, it was closely identified with infrastructure-related sectors. During 2009-10, the rebound after the great financial crisis (GFC) was driven by domestic consumption and banks. The current uptrend since August 2013 could easily be identified as a mid- and a small-cap driven rally.

In a country where equity penetration remains low, the recent investor adoption of mid- and small-caps needs to be analysed. Given the higher volatility of this segment historically, investor interest in it has been limited. In January 2006, mid-cap mutual funds were just 10% of the total equity assets under management (AUM) of the industry. By January 2016, this had zoomed to 23% of equity AUM.

The genesis of this increase can be traced to an interesting development-the launch of closed-end schemes during calendar years (CYs) 2013 and 2014. Around August 2013, with valuations of mid- and small-caps languishing below their historical averages and global turmoil affecting emerging markets, the launch of closed-end schemes with short duration acted as a 'trigger' for investors returning to equities in general, and in mid- and small-caps in particular. As is usually the case, the early birds registered impressive returns; over 100% in less than a year. The common theme that ran across these funds was a concentration of mid- and small-cap stocks. By early CY15, regulatory changes in commission payable on closed-end structures led to a shift towards a more investor-friendly structure: open-ended mid- and small-cap funds.

On the other hand, large-cap and diversified funds (a mix of large- and mid-caps), the traditional segment in which equity flows were directed, suffered continuous outflows from foreign institutional investors (FIIs) during CY14 and CY15. The mid- and small-cap segment, such as the Russell 2000 index in the US, was viewed by investors as a relatively safer domestic focused play in an increasingly uncertain global scenario. As a result, mid- and small-cap funds emerged as the fastest growing segment within equity AUM of the mutual fund industry. A category, which just a decade back did not account for more than 10% of the total equity AUM, now accounted for over 23% of it.

"This time is different" is usually the refrain bandied every time a new trend emerges in the stock market. As mentioned earlier, every bull phase is based on excess returns in a specific segment. Lured by the attractive returns of this segment, investors have rewarded it with a steady inflow across mutual fund and portfolio management service (PMS) platforms. Recent outperformance, like sunshine, can blind investors from focusing on other issues. Has the same been the case with mid- and small-cap funds over the past 18 months? Have investors asked these key questions before hooking on to the current bull phase bandwagon to wealth?

How large is the investible universe of mid-caps stocks and how does the size of the mutual funds appear relative to the size of this opportunity? Mid-cap funds AUM, as mentioned earlier, has touched historic highs since CY15. How big is the investible universe of stocks that qualify for the mid- and small-cap theme? The BSE 500 (S&P BSE All Cap) Index has a market capitalisation of ₹91 trillion, with a free float of ₹42 trillion. Of this, the top 100 companies, as represented by BSE 100 Index, have a free float of ₹33 trillion, thus the balance universe, which would also correspond to mid- and small-caps, has an investible universe of ₹8-9 trillion. Against this, the AUM of mid-cap funds has already crossed ₹0.8 trillion. If we add PMS schemes, estimated at ₹0.15 trillion, the total AUM of this segment is close to ₹1 trillion, almost 15% of the total investible universe. This equation becomes even more acute if we add the mid-cap allocation of diversified schemes (large or mid-cap schemes with mid-cap exposure of 25-40%), which is around ₹1.8 trillion. This would give an additional mid- and small-cap component in the region of ₹60,000-75,000 crore adding up to approximately 30% of the investible universe.

What has been the earnings growth of this segment vis-a-vis large-caps?

Given that the Nifty earnings growth for the past 3-5 years is one of the lowest over the past 10-15 years' history, have the mid-cap stocks generated far superior earnings growth during the period? The first problem one faces while trying to ferret information at an aggregate level is the inappropriateness of the mid-cap indices. The NSE Mid Cap Index, used by a large number of mid-cap schemes has, as per Bloomberg data, registered an earnings de-growth of 36% for the trailing 12 months' period. This is largely accounted by 13 companies out of the 100 in the index, which have reported losses (including Bank of India, Steel Authority of India Ltd, Jindal Steel and Power Ltd, Cairn India Ltd, JSW Steel Ltd, IDBI Bank Ltd, Canara Bank, Tata Communications Ltd, Century Textiles and Industries Ltd, Suzlon Energy Ltd and GMR Infrastructure Ltd). No wonder mid- and small-caps are touted as a bottom approach. Even after discarding loss making companies from the index, those with positive profit after tax (PAT) reported a growth of 5%. The 3-year compounded annual growth rate (CAGR) of positive PAT reporting companies that are part of the NSE Midcap Index was 5%. Similarly, for Nifty, if we only take positive PAT generating companies, 3-year CAGR of such a grouping of companies was also 5%.

Even a 'curated' portfolio of 50 best performing mid-cap companies reflects an interesting trend. While the PAT growth of such a curated portfolio is higher than either the Nifty or NSE Midcap index, with a three-year CAGR of 13%, the expansion in valuation is at an even a faster clip. On an absolute basis, the price-to-earnings (P-E) ratio has doubled from 19.7 to 37.3, a growth of 23.7% in CAGR terms over past the three years.

This brings us to the next important question. At what valuations do mid-caps trade at? How are they placed relative to large-caps?

Mid-caps have traditionally traded at a discount to large-caps. Even during extended periods of mid-cap returns outstripping large-caps (2003-07 and 2009-10), they traded at a discount to large-caps. However, over the past year, mid-caps have started to trade at a premium to large-caps. Currently, NSE Midcap 100 Index trades at a premium of 650 basis points to the Sensex on a trailing basis. (One basis point is one-hundredth of a percentage point.) This could be attributed to the sharp de-growth in earnings registered by the NSE Midcap index, thus expanding its P-E by some extent. If we were to compare the companies generating PAT (and exclude loss making companies) forming part of NSE Midcap Index, the P-E falls to 18.0x. However, when compared to Nifty P-E, this "adjusted" P-E gap has shrunk to the lowest level since 2007.

Lastly, a common perception that many investors have is that FIIs are absent in the mid- and small-cap segments, while large-caps have high FII shareholding. While data on Nifty or even BSE 100 companies and FII participation is easily available, covering the same over the vast mid- and small-cap space is more difficult. However, if we were to focus on stocks that are in the BSE 500, excluding those that are part of BSE 100, the FII shareholding remains fairly high. FII holdings in companies ranked 101 to 250 by market cap is 2x the MF holding. Similarly, for companies ranked 251 to 400, this is 60% higher than MF holdings. For investors, the perception that you could hide from FIIs by investing is just a mirage. You can run, but you can't hide.

At the start of the current rally, mid- and small-caps were trading at a distinct discount to large-caps. Aided by the strong performance of closed-end schemes, inflows into mid- and small-caps have touched an all-time high over the past 12 months. Mid- and small-cap schemes today account for 23% of the total equity AUM of the mutual fund industry, as against 12% just three years back. With no "comparable" mid-cap index to benchmark against, investors seem to have been driven by perceptions rather than hard facts-earnings growth, P-E valuations and size of the universe. The relentless expansion of P-E multiples in this segment should be a clear warning signal for investors. The High Growth Index for a 3-year earnings CAGR of 13-14% has been rewarded by doubling of P-E multiples during the same period. This reflects the paucity of earnings across the market during this period.

Finally, return expectations of investors need to be managed. The starting point P-E multiples (three years back) were roughly half of the current levels and were a key driver of returns over the past three years. Returns will reflect the earnings growth of the segment rather than any further re-rating (as was the case during the past three years).

For investors, asset allocation should be the clear route for wealth creation through investing in equities. The recency bias of returns of various asset classes or sub-segments within an asset class tends to impact investors in their asset allocation process over the short term. Rather than chasing the highest return generating asset segment, the focus should be to generate the most consistent, risk-adjusted returns over the medium to long term. Short-term tactical allocation should be made with the objective of correcting such biases over the medium term.

One such course correction that investors need to make after the strong push towards mid- and small-caps over the past three years is to balance their portfolios between large- and mid-caps. Rather than seek the thrill of the highest short-term return, the focus should be to generate consistent medium- to long-term returns through disciplined asset allocation.

The Greek hero, Odysseus, devised a novel strategy of blocking his men's ears and restricting his own movement to avoid being lured by the music and the songs of the Sirens. However, investors need not go through such extreme measures to correct course. All they need to do is get back to asset allocation in a disciplined way to build a long-term portfolio. While the long-term potential of mid-caps is not in doubt, near-term judicious asset allocation is needed.

In arrangement with HT Syndication | MINT