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In Focus: Donning the Mid-Cap Hat

Many mid-cap cos may not become large-caps, but can deliver fantastic returns

Mid-cap stocks are notorious for being a high-risk and high-return category of equity investments. When these stocks do well, they appreciate more than large-caps, which typically happen in the bull markets. In bear markets, they can fall much faster than large-caps.

When the markets tanked in May and June 2006, mid-cap and small-cap stocks were smashed, with several of them halving in value. Compared to the Sensex decline of 30.6 per cent, the BSE Mid-cap index fell 38.25 per cent from the high in May to the low in June. Small-caps fell even more as the BSE Small-cap index collapsed 43.1 per cent. In the subsequent recovery, the mid-cap and the small-cap indices have done rather well, though they may have lagged slightly behind at about 30 per cent, as compared to the Sensex gaining 31.5 per cent between the June low till August 25.

Small investors typically have a larger exposure to mid- and small-caps than large investors, and such movements damage their financial position more.

In most bear markets of the past, small and mid-caps have taken several years to come back to the same levels seen in the bull market, and that too, if they manage to come back.

This time, the mid-caps and small-caps had rallied for three years till May 2006. A lot of institutional investors have reposed their faith in this category.

Many companies here became competitive at the international level, chief among them in the pharmaceutical and auto ancillary sectors. Then, there are sectors like cotton textiles, paper or sugar, which have mid-caps as the sectors are small.

Mutual funds too hold these stocks in high regard. And that is exactly why the average diversified equity mutual fund is not performing as well as an index fund these days. In the past year, the average equity fund has earned 34 per cent, while a passive index fund has delivered 42 per cent. The average diversified equity fund has an exposure of 49 per cent to mid- and small-caps, and since these stocks have not done as well as the large-caps that the index funds track, the performance of index funds has been a runaway hit.

Coming back to the future of mid- and small cap stocks, the performance should improve if the bull market continues. Investors, who have been pushing the market with large-cap buys, are likely to find a safe haven in mid-caps, which are doing well financially and are available at cheaper valuations compared to their large-cap peers. Yes, there are companies with an uncertain future in the category of mid- and small-caps, but there are enough companies that may not become tomorrow's large-caps, but can deliver fantastic returns.