Invest In Small, Mid-Caps With At Least 3 Years Horizon

COVID-19 hit the markets in February, and the carnage continued for four weeks. All indices shed nearly 40 per cent by the third week of March. The general market belief was that while large-caps would recover first, the mid & small-caps may take a long time to come back. As a comparison, this belief was sentimentally accepted. However, it didn’t have any empirical support, as midcap stocks witnessed a better recovery than large-caps in the post-global financial crisis 2009-11 period.

Starting April, the midcaps recovered as strongly as the large-caps from their March lows. A large stimulus led it from the Fed and a domestic recovery that was significantly better than expected. The Nifty-50 and Midcap 100 indices are up 75-80 per cent from the lows, and both indices are at 110 per cent of their pre-COVID levels. While small and midcaps have risen from the March lows, they are still much below their January 2018 highs. Nifty Small-cap 100 is 28 per cent below while Nifty Midcap 100 is 6 per cent below their respective Jan 2018 high while Nifty is up 28 per cent during the same period.

History suggests that such divergences do not exist for too long. After such large underperformance mid and small caps generally outperform large caps over the subsequent 18-24 months. The current downturn in the mid-small caps is already one of the most prolonged and profound, especially for small caps. On a risk-adjusted basis, broader markets are looking attractive from a medium-term perspective.

Many companies in the mid-small cap segment across various sectors like tiles, plywood, agrochemicals, auto ancillaries, speciality chemicals, pharma, consumer durables and IT, are positioned on their balance sheet and cash flows. These companies would get a disproportionate market share as demand recovers. Competitors with weak balance sheets would be unable to meet that demand.

Our focus is on positioning the portfolio in such sectors and companies, to take advantage of the earnings recovery. Also, we believe 2021-22 would be a more normalised year for economic growth. As the economy’s growth rate improves, we believe mid-small companies would benefit the most. We believe that a bottom-up stock picking approach would be rewarded in mid-small space.

Sectors that are likely to see improved demand momentum in coming years are represented by the mid-small cap space. For example, Indian companies in sectors like speciality chemicals, agro-chem, electronic contract manufacturing, Defence, furniture, auto ancillaries and consumer durables can benefit from this shift towards indigenous manufacturing. Companies in these sectors would benefit from the Atmanirbhar Bharat movement and as COVID-19 has led to a rethink of global supply chains' robustness and resilience.

Indian companies in the sectors stated above, which are globally cost-competitive, can benefit from this shift. The government’s recently introduced Production LinkedIn (PLI) scheme could prove to be a game-changer as far as a shift towards domestic manufacturing is concerned. Global demand for some products in these sectors can be quite large. Suppose an Indian company gains some share of that global demand. In that case, it can lead to substantial growth opportunity over the next 3-5 years.

Common myth and narrative are that mid-small caps get hit the hardest during a deep crisis like COVID-19. Reality is somewhat different. More than 200 category leaders within stocks ranked 100-650th by market capitalisation. These leaders have only gotten stronger over the past decade.

Valuations of midcaps after a year are only marginally higher than large-caps. Historical data shows that midcaps enter an extended underperformance cycle only after crossing a 40 per cent valuation premium. Furthermore, on 3-year rolling compounded annual growth rate (CAGR) basis, midcap has underperformed large-caps. Hence, the scope for further performance. Midcaps tend to outperform large-caps over the longer term. The average of 10-year CAGR for midcaps, taken for every year since 2008, shows that these outperformed large-caps by 4 per cent. Data also indicates that midcap schemes have been the most superior wealth creators in absolute terms over longer periods within equities. Returns have been higher than large Exchange Traded Funds as well.

Data since 2000 shows that midcaps perform very well during periods of high global liquidity. A low-interest-rate environment also disproportionately benefits mid and small-cap businesses as their capital costs are higher than large caps. These factors, combined with the ongoing better-than-expected recovery across domestic sectors are an attractive combination for the mid-small cap segment to do well over the medium term.

Finally, asset allocation should be a function of an investor’s risk appetite and investing time horizon. It would be best evaluated by a financial advisor based on the investor’s individual circumstances. Having said that, we would advise investors to look at the midcap and small-cap funds with a minimum three-year horizon.

The author is Fund Manager Kotak Mahindra Asset Management Company

 DISCLAIMER: Views expressed are the author's own. Outlook Money does not necessarily subscribe to them. Outlook Money shall not be responsible for any damage caused to any person/organisation directly or indirectly.