Why the mid-cap mania should worry you

Last three similar spells have preceded falls, and this one trumps them all

Will it be different this time? The mid-cap index is again running ahead of the benchmark index. Whenever in the past that has happened for a long-stretch — whether in 2008 or 2010 or 2013 — the market has corrected subsequently.

To be specific, the BSE Mid-cap index has outperformed the BSE benchmark Sensex by 26.6 per cent since April last year, in its biggest and longest period of outperformance since the Mid-cap index data became available in 2005. The index has risen 58 per cent since April 2014, compared with the 25 per cent appreciation for the Sensex and 27 per cent for the National Stock Exchange’s Nifty during the period.

The current rally in Tier-II and -III stocks is much stronger than in the previous market highs, such as in late 2007, 2010 and 2013. For example, in 2007-08, the mid-cap index had outperformed the Sensex by 16.5 per cent in the run-up to the market crash of January 2008. The mid-cap index had gained 24.3 per cent in 50 trading sessions up to January 7, 2008. By comparison, the Sensex had appreciated only 5.7 per cent during the period, and the Nifty by 6.3 per cent. The Sensex made a new high the next day (January 8) and began to correct thereafter.

In 2010, the mid-cap index outperformed the benchmark indices for over a year from October 2009 to November 2010. At one point, it was up 17 per cent vis-a-vis the Sensex and 19 per cent versus the Nifty.

“When one looks at market cycles over a five- to seven-year period, there might be periods of outperformance on account of a direction of investment flows, but there is always a reversion to mean. The numbers currently suggest that the premium in mid-caps is pricing in a fair amount of growth,” says Swati Kulkarni, executive vice-president and fund manager (equities), UTI Mutual Fund.

However, she declines to predict a fall. “One cannot say for certain that a reversal will take place at a certain time. One can see situations where mean reversion may not happen for years.”

The rally in mid-caps is attributed to strong flows from domestic retail investors and mutual funds. The shareholding pattern of the BSE 500 companies shows a relative withdrawal by foreign investors and a gap being filled by domestic investors.

FIIs’ ownership of the BSE 500 companies declined to 23.9 per cent at the end of June this year, from a record high of 26.3 per cent at the end of March. During the three-month period, public (non-institutional) holding increased to 10.3 per cent from 8.6 per cent, while domestic institutions (insurance plus mutual funds) raised their effective ownership to 11.3 per cent from 10.3 per cent at the end of 2014-15. The flows have since slowed down, raising fears of a market reversal. Mutual funds have seen their highest redemption this year in July.

“It is always tough to justify a rally if foreign investors turn bearish. FII flows are smart money, trying to pre-empt events. In contrast, the domestic flows have always been cyclical as investors try to ride the market momentum,” says Dhananjay Sinha, head of institutional equity at Emkay Global Financial Services.

Bulls, however, rubbish the comparison with previous market corrections. “When you look at periods like 2008, mid-cap valuations had run high. But the subsequent fall was on account of the global economic collapse in 2008. So, it might not be appropriate to draw a conclusion based on such events. When it comes to such issues, one has to consider if there is too much leverage or too much speculation. I don’t think it would be fair to say either is true at this point. If there is a correction this time around, it is likely to be technical,” says Prabhat Awasthi, managing director & head of equity, Nomura India.

Devang Mehta, senior vice-president & head (equity sales & advisory), Anand Rathi Financial Services, agrees: “I think mid-caps remain a good buy. The valuations might look steep at some counters but that is largely because many of them continue to grow faster than large-caps and Sensex companies. Besides, top mid-caps don’t have balance-sheet issues and global risks associated with many Sensex and Nifty stocks.”

Others are looking for cues from corporate earnings. “If earnings growth is on expected lines, the mid-cap valuations will not look unjustified. One will have to look at the second half of 2015-16 to get an idea of whether earnings expectations would be met,” says UTI Mutual Fund’s Kulkarni.