Small, mid-caps outdo markets

Strong earnings growth reported by select companies sees resurgence of investor interest in these segments

Mid-cap and small-cap stocks have outperformed the market, though the benchmark indices are struggling to maintain an uptrend since the S&P BSE Sensex recently hit an all-time high, after nearly six years.

Both the BSE mid-cap and small-cap indices have gained by a little less than one per cent each, as compared to the 4.2 per cent decline in the S&P BSE Sensex thus far in November. The S&P BSE Sensex has lost 957 points from its record high of 21,239 on November 3.

Year-to-date (YTD), both the indices had underperformed the market, falling a little over 20 per cent each, while the S&P BSE Sensex remained flat till September-end.

“The profitability erosion in smaller companies has been worse in this cycle, with poor pricing power making it difficult to pass on higher input costs,” says Nick Paulson-Ellis, India head at Espirito Santo Securities.

The strong earnings growth reported by select companies in the mid-and-small cap segment has seen investor interest return to this space. Since September, the mid-and-small cap indices have rallied by nine per cent and 8.5 per cent, respectively, as against a 4.7 per cent gain in the benchmark index.

“Given that the market was near an all-time high, there is a tendency to take a breather, in technical parlance. At that point of time, the valuations of mid-caps and small-caps looked attractive, given the run- up in large-cap valuations. Further, any improvement in business prospects for large-caps translates into better business prospects for mid-caps. This is the valuation rationale,” said Ravi Shenoy, assistant vice-president (mid-cap research), Motilal Oswal Securities.

“The Reserve Bank of India (RBI) started to review its tight money policy around September. This breather, in terms of higher liquidity, has been reflected in working capital for mid-and-small cap companies that supply to large-caps. This is the financial rationale for their rally,” he adds.

Of 644 stocks from the S&P BSE mid-cap and small-cap indices, 311 have outperformed the market, gaining a little 11 per cent since September. Of these, nearly 100 have rallied by over 25 per cent. Some of this has been due to a strong show in the September quarter.

“The results in the mid-cap space have been a mixed bag, as it has been for the frontline companies. Positive surprises have, however, outweighed negative ones, given that our expectations were set low. Capital-intensive industries still continue to post poor numbers, while consumer-facing and asset-light companies have posted good numbers. We believe companies with a consumer niche, farmer/rural-focused products and export base will continue to do well,” Shenoy says.

Ceat, Sintex Industries, KEC International, JK Tyre Industries, Escorts, Tata Communications, Alembic Pharmaceuticals, TV Today, Suven Life Sciences and Arvind Limited have rallied by 40–90 per cent, after reporting strong earnings growth for the recently concluded quarter.

Investors should look at quality names with good margins, low levels of pledging, sound balance sheets and no major governance issues while investing in this space, say analysts.

“Some of the stocks we like in the mid-cap space include Bajaj Finserv, Max India, Radico Khaitan, Balkrishna Industries, Development Credit Bank and Redington,” says Nick Paulson-Ellis of Espirito Santo.

Motilal Oswal Research is positive on Berger Paints, Supreme Industries and Swaraj Engines. “The realty sector is going through a tough phase. However, one way of playing this space is through the housing finance companies that will stand to benefit from an increase in liquidity from a long-term perspective. Gruh Finance and Repco Home Finance are investment-worthy stocks in this space,” says Shenoy.