Where are the mid-caps headed?

In the last four month, auto, FMCG and pharma shares did well while metals, cement, construction, PSU banks have all lost ground

The Nifty and the Sensex hit their all time highs in March 2015, in the wake of the Budget. However, the CNX Midcap and the S&P BSE Midcap index have hit their respective all-time highs in July. The two indices have a close relationship, being constructed on similar lines. The BSE index has a smaller population of 77 stocks versus the NSE Midcap 100 -stock-index. As many as 44 of the stocks are in common, so the correlation in index movements is not surprising.

Breadth in a market (a situation where more shares are seeing advances, and fewer shares are seeing declines) is often considered a sign of sustainability. A situation where the benchmark index has lost ground but the majority of shares are gaining, suggests that the sentiment is still bullish. In contrast, a narrow market where a few shares are gaining can be deceptive.

Most indices are based on market capitalisation (or a variation, free-float market cap). If a few high market capitalisation shares push the main benchmark indices up, the market may seem bullish even if the majority of stocks are losing ground and breadth is poor. In such a case, the market sentiment may be bearish and the uptrend may not be sustainable.

One danger in a situation of good breadth can be the nature of the participation. Sometimes high breadth is driven purely by large-scale retail participation. It is well-known that retail investors tend to enter markets late, often at a point where the institutions have started booking profits and reducing equity exposures. It is also true that retail investors often speculate in small caps where institutions will not be interested.

However, this does not appear to be the case in the current situation. These two midcap indices actually contain a significant number of large stocks and they are "midcaps" only in comparison to the Sensex / Nifty giants. In fact, a very large number of the stocks in these two indices are available in the derivatives segment. About 24 per cent of the NSE's total equity trading volume is contributed by stocks belonging to this index. This means that they are liquid enough to attract the attention of both domestic and foreign institutions.

In the first quarter (April-June 2015) the FIIs and DII have, in combination, bought approximately Rs 27,000 crore worth of equity. The DIIs actually bought over Rs 32,000 crore, while the FIIs were net sellers of a little over Rs 5,000 crore. In July (July 1- 17), the net institutional buying is about Rs 1,300 crore - the FIIs have been net buyers while the DIIs have sold a little.

So, the institutional position has been net positive through the past four months. During that period, the Sensex and Nifty have seen corrections, but the midcaps have risen. This must be due to institutional buying since these are all liquid stocks with substantial institutional presences and retail investment would hardly shift their prices.

The pattern of returns is not surprising. By and large, the bulls have bet on the same industries as they have done in the benchmark indices. Pharma shares have done well, the automobile industry and auto-ancillary shares have done well, FMCG shares have done well. Conversely, metals, cement, construction and PSU banks, have all lost ground. The Midcap index has an average PE of 23x, which is about the same as the Nifty.

This appears to be a situation where institutions have worked their way through the top rank of companies (in terms of market cap) and are now focussed on the second rung of companies. While that focus lasts, these stocks will continue to outperform the Nifty.