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How to walk the mid-cap tightrope

With Sensex beating both mid- and small-cap indices comfortably over a 5-year period, experts advise caution while investing in these

Joydeep Ghosh & Ashley Coutinho 

In the past few months, financial planners have been inundated with calls from investors who want to put their money in the mid- and small-cap stocks or funds. "The difference between the performance of large-cap and small-cap indices has been so stark that everyone is asking if more exposure to the latter has become a necessity," said Hemant Rustagi, chief executive officer, WiseInvest Financial Advisors. While the Sensex is up 21 per cent in the past year, the mid- and small-cap indices are up 43 per cent and 47 per cent, respectively.

Another reason investors are flocking to these segments is even in the recent correction, the Sensex has been battered more than them. Rajesh Cheruvu, chief investment officer, RBS Private Banking, India, said: "On an average, the large-caps have seen 15-16 per cent correction from their 52-week high, whereas the mid-caps haven't fallen so much."

Still an opportunity?

Yes, most believe that one cannot ignore a segment that is offering significant returns and has the potential to do so in the future, as well. But experts are advising that investors take a tempered approach.

Investors who are heavily into large-caps or multi-caps can shift some part of their portfolio into schemes which have a good 70-80 per cent exposure in mid-caps and the rest is in large caps. This will allow them to get a strong flavour of these stocks in the portfolio but if the market turns around and these stocks fall fast, the fund manager will have the option to buy more large caps and protect the downside. "Some rebalancing has to be done within the equity asset class in case of investors who have loaded themselves with only large cap funds or stocks. However, I would not advise going all out into mid or small cap," added Rustagi.

But all this euphoria comes with a warning. As G Chokkalingam, founder, Equinomics Research & Advisory, said: "Retail investors should not chase stocks that have already become multi-baggers. Unfortunately, they get excited with such stocks and miss out those that have a potential to become one. This requires the ability to select stocks that could do well in the future, a tough task for most investors."

The strategy?
Mid- and small-cap stories can be mouth-watering prospects when they have already become multi-baggers but there can be long periods of frustration and, sometimes, failure as well.

Chokkalingam suggests one strategy. "Investors who are impatient and who try to compare portfolio returns with the Sensex or Nifty on a monthly or quarterly basis should not allocate more than 10 per cent to mid-caps. However, those who are focussed on the fundamentals and the growth potential can even invest up to 50 per cent of their equity portfolio in mid-caps," he said.

Someone with a good risk potential can be more aggressive by having a concentrated portfolio of just eight to 10 mid-cap stocks. It can add a huge kicker to your portfolio. For example, let's assume you take a one per cent exposure to stock X that is quoting at Rs 100 vis-à-vis someone else who has invested five per cent in the stock. If the stock moves up 500 per cent, the first investor will make Rs 5 while the second investor will get Rs 25. However, those with a more conservative approach can spread their investment over 20 stocks.

Cheruvu said: "We suggest a gradual allocation or a staggered entry rather than investing lumpsum upfront. The market is likely to move sideways in the next three to four months, which could offer a good entry point to investors, led by volatility. Investors should prefer companies with good managements and robust business quality over mere high growth as a criterion, to achieve sustainable performance."

The ideal size to construct portfolios is about 20 stocks. Diversification helps in risk mitigation.Inexperienced investors could consider portfolio management services or mutual fund route to invest in mid- and small-cap stocks. Informed professional managers are expected to do the job of stock selection and tracking effectively as they will have the benefit of size and superior access to research.

How to select?
Selecting mutual funds or stocks in the mid- or small-cap space can be a nightmare. Reason: there is a huge difference in performance. In case of funds, it is best to undertake research for schemes which have a good track record or three to five years or even more. In case of stocks, the number crunching could be more difficult.

In case of stocks, Chokkalingam warns that even after incorporating one to two year's forward earnings, if the price-to-earnings multiple does not shrink or become lesser than peers that are market leaders, than that it is a red flag. But if stocks do look cheaper after such an exercise, investors should invest in small proportions. Remember, it can take three years or more for a multi-bagger story to unfold.

The most important thing: While the mid-cap and small-cap indices have outperformed the Sensex in the past year, over a three-year period, they have given similar returns to Sensex. Interestingly, the Sensex has beaten the small-cap and mid-cap indices comfortably over a five-year period. The lesson: don't exit large caps completely.

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First Published: Sun, April 26 2015. 23:20 IST