Mid-caps: The way ahead

By now you would have come across many articles mentioning the high valuations in midcaps. While it is true that the days of easy returns in this space are over, one needs to dig deeper and pursue a disciplined approach to do well.

Broader mid/small-cap valuations appear expensive. But if you break the segment down into individual sectors/stocks, you get a different picture. For example, the current P/E multiple for the NSE Midcap 100 Index is about 35x. However, this is elevated because a large number of companies in the index are loss-making currently. If you look at the basket of profit-making companies within the index only, then the P/E multiple goes down to 19x which is not completely unfair.

The mid- and small-cap universe is very diverse and headline valuations may not represent the stock-specific opportunities available. As compared to the Nifty 50, the BSE Small and Midcap Index has representation from more than twice the number of sectors:33 vs 15. Many of the high-growth sectors such as media, chemicals, logistics, retail, etc. are not well represented in the large-cap space.

More opportunities may become available within this space in the future from listing of companies in emerging segments such as healthcare services, insurance, micro-finance, consumer discretionary, etc.

Most sectors that are linked closely to the domestic economy are represented in the mid-small cap space. Many have improved their balance sheets over the past few years and have significant operating leverage. This, combined with an improving demand environment, can lead to substantial profit growth in the coming years.

For portfolio managers, the endeavour is to search and invest in 50-60 companies that can be compounding stories over the next three-five years from our universe of 300 plus companies and overall universe of 5,000 plus companies.

As the valuation of midcap basket is at a premium to large caps, the valuation multiples may not expand materially hereafter. In future, returns will be driven more by earnings growth.

Have valuation principles for mid/small cap categories changed over time? We do not believe that the core principles have changed. Our core tenets of valuing companies based on their cash flows and balance sheet strength remain the same. Businesses that have a distinct competitive edge in a scalable opportunity, and those working with capital efficiency, are most likely to generate sustainable wealth for shareholders.

With flows continuing into mid- and small-cap funds, investors should be cognizant of the risks arising from concentrated stock portfolios and the illiquidity associated with some of these stocks. In case of reversal of flows, portfolios with concentration and illiquidity could be the worst hit.

In the middle of all the chaos, however, one must not forget that it is discipline, sound fundamental research and patience that lead to the right stock picks, which in turn helps bring out consistent outperformance.

Volatility is inherent to equity markets. At the same time, volatility can also be used to one's advantage by investing in good businesses at lower price points. We advise investors to go through the systematic investment route in mutual funds to build a long-term portfolio for significant wealth creation.

The author is CIO-equity, Kotak Mahindra AMC