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What mid-caps to buy?

As valuations of large-caps look stretched and earnings downgrades loom, the market looks at strong mid-caps

Malini Bhupta & Vishal Chhabria  |  Mumbai 

Through the past 12 months, the broader have returned 24 per cent. But with earnings showing no signs of picking up substantially in the near future, strategists are looking for value elsewhere, as large-caps are beginning to look expensive. stocks have outperformed the benchmark indices. Through the past six months, while the Sensex has risen three per cent, the index has gained 10 per cent. Though institutional investors, especially long-only funds, prefer large-caps, mid-caps are critical to generate alpha (market-beating) returns. This trend is expected to continue through the medium term. A recent correction in these stocks has made them more attractive.

Unsurprisingly, through the past couple of weeks, brokerages have come out with their preferred picks. When it comes to choosing large- or mid-cap stocks, sectoral preferences don’t vary substantially. But, since buying or selling large quantities of mid-caps might impact the price of a stock significantly, big investors prefer attractive valuations before entering these stocks. Apart from valuations, there are other crucial factors to be taken into account.

R Sreesankar, head of research at Prabhudas Lilladher, says while picking mid-caps, the key focus is on the sustainability of earnings and cash flows, as such companies tend to require capital to grow. He cites the example of infrastructure companies in India, which ran into trouble not because they didn’t have orders, but because raising growth capital was a hurdle. Prabhudas Lilladher is overweight on sectors such as financials, medium & heavy commercial vehicles, information technology and infrastructure.

Edelweiss Securities, Prabhudas Lilladher and Kotak Institutional Equities, among others, have come out with potential mid-cap winners for whom, they say, earnings growth through the next few years will be more than 20 per cent. To arrive at a list of potential winners, Edelweiss has used strong filters such as earnings predictability through the next five years, financials (revenue growth in the past, return on equity and cash flow analysis) and leadership position.

Kotak Institutional Equities, on the other hand, sees an opportunity in agro-chemicals, as India offers tremendous opportunity for growth in this regard. The brokerage firm says usage of pesticides in India is among the lowest in the world; India used only 0.6 kg/hectare of pesticides in 2011-12, against 13 kg/hectare in China and 7 kg/hectare in the US. “The Indian agri-chemical market is a fifth of the size of the Brazilian market, despite India’s gross cropped area being twice that of Brazil’s.” The brokerage house’s top picks in the sector are Dhanuka and PI.

TOP MID-CAP PICKS BY PRABHUDAS LILLADHER
Company Investment Rationale
Cummins The stock is trading at 23.2x FY17E earnings. Outlook continues to be positive, given the strong ramp-up in exports
Ashok Leyland Demand recovery in M&HCV to aid company. Volume growth of 23.5% CAGR over FY15-17 likely
Federal Bank Analysts betting on management’s ability to drive business, which will improve return ratios and keep a tab on the level of slippages
Mindtree Earnings downgrade unlikely despite currency woes. Revenue growth to be aided by Discoverture acquisition
Hexaware Technologies Strong growth from top clients, high dividend pay-outs to continue to support return on equity
JK Lakshmi Cement Entry into profitable eastern region and consolidation in Gujarat a big driver
KPIT Technologies Strong deal closures and better than expected revenue growth drives earnings upgrades
Ashoka Buildcon Well-funded infra player expected to be key beneficiary of revival in economy and pick-up in toll revenues

Across sectors, strategists are looking for companies that are likely to grow in double digits through the next few years. Among the preferred sectors are automobiles, auto ancillaries, information technology, financials and agri-chemicals.

Among stocks, Ashok Leyland is expected to benefit substantially, as the commercial vehicle cycle picks up further. Already, volumes for the company and the sector have started rising and freight rates are ruling firm. is another stock that investors with a two-three-year perspective might consider. Among the big triggers for Natco is the launch of a generic version of Copaxone (used to treat multiple sclerosis) in September this year. The company is also expected to launch anti-viral medication Tamiflu in August next year. If Natco is able to launch these drugs (annual sales of $1.8 billion) and get enough traction, these could quadruple the company’s earnings in 2015-2017, says Hitesh Mahida of Antique Stock Broking.

While this indicates the growth potential investors should seek, they should also consider the track record of a company and its promoters, before finalising their investments. Typically, a company should have seen at least two up- and down-cycles and should have the bandwidth to take ‘timely’ corrective/remedial action when a situation warrants.

Usually, a company with manageable or low debt alone should be considered. Going by history, many companies have turned from large-caps to mid-caps because of high leverage in their books; examples include JP Associates and Suzlon Energy. Even as these companies are taking corrective measures, investors have lost significant capital in these.

Often, small- and mid-cap stocks go off the radar or disappear, for various reasons.

Investors, however, would do well to have some filters. For instance, apart from valuations, companies with a robust financial track record and growth potential, a clear niche or a high competitive edge in business, strong corporate governance practices with professional managements alone should be considered. Also, their businesses should be relatively easier to understand and apart from being among the leading players in their sectors, companies should have the wherewithal to adjust to technological changes. Importantly, their business should be least determined by regulations such as pricing limits and subsidies, which weigh heavy on growth.

TOP MID-CAP PICKS BY EDELWEISS
Company Investment Rationale
Canfin Homes Company has maintained NIMs of 2.9% over five years. Loan book has grown 19% CAGR over 10 years
Cholamandalam Finance Net interest income has grown 33% CAGR over five years with stable margins
Mayur Uniquoters Among top two Asian suppliers of artificial leather, its sales have grown at 33% CAGR over 5 years. Company likely to generate RoE of 30%
Natco Pharma Company has grown at 21% CAGR over 7 years. Dominant position in the generic oncology space in India and niche player in US
Ratnamani Metals A leader in industrial project pipes, sales have grown 27% CAGR and PAT by 43% over 10 years. Company expected to sustain growth levels
Suprajit Engineering Leader in automotive control cables for 2-wheelers, its earnings have grown by 20% CAGR over 10 years aided by increased market share
Indo Count Industries Third largest exporter of bed linen from India and fourth largest bed-sheet exporter to the US. Company moving towards value-added products

Typically, companies with such attributes turn out to be winners in the long run. In fact, companies such as Eicher Motors and Page Industries have turned out to be multi-baggers.

However, not every mid-cap will deliver such huge returns. In fact, only a few might. To make good returns from the mid-cap space, investors will also have to monitor their investments and subject these to SWOT analysis at intervals of 6-12 months, besides checking on the management’s ability to take the business onto the big league.

First Published: Mon, March 30 2015. 22:50 IST
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