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A recent advisory by Deutsche Bank has focused attention on the mid-cap sector. As the report pointed out, mid-caps tend to outperform large-caps in a major bull run and this rally may conform to that trend.
In fact, the BSE Mid-cap Index has done very well, by gaining over 30 per cent since August 2013. During this same period, the large-caps as tracked by the Sensex/Nifty indices, rose around 18-19 per cent. Mid-caps and small-caps are usually high-beta with respect to large-caps. This means that smaller stocks tend to outperform during rallies and they tend to underperform during bearish periods.
There are several reasons for this. One is that growth (or contraction) in percentage terms will be higher for smaller businesses due to the low base effect. Another reason is that mid-caps tend to attract attention from both institutions and retail investors, whereas retail attention is irrelevant for large-caps. Relatively smaller investments can push share prices up more sharply in mid-caps than in large-caps.
The research report presumes that economic conditions are likely to improve, or at least not get worse from here onwards. Deutsche Bank believes "growth has bottomed, currency has stabilised and the twin deficits have shown a marked improvement. These factors should be favourable for an economic recovery, which could be further bolstered by a decisive electoral outcome."
Given that mid-caps are reasonably valued, this advisory from an influential brokerage, could, in itself, help push mid-cap stocks higher. Bharat Forge, HPCL, Jain Irrigation, LIC HF, Shree Cement, Shriram Trans Fin and YES Bank are the top picks selected in this report. There are a couple of points, which are probably worth making about these selections and about the thrust of this report in general. In my opinion, HPCL is best avoided since it's a PSU and government policy in the oil and gas sector has never been remotely close to sensible.
Other than HPCL, these are all reasonably well-run businesses. LIC HF is also government-controlled but it is well run and it has a strong focus on a very specific segment of the financial sector. These are all cyclicals and a turnaround in the economic cycle would probably mean that they should yield high-beta returns. All of them are capital-intensive (three are financials) and the implication is that rates should be moving down if they are all going to do well.
These are all constituents of the BSE Mid-cap index. But they would not necessarily be classified as mid-caps by everyone. Shree Cement is the only stock that does not have stock futures available in the derivatives segment. Many of these stocks feature as members of the Nifty Junior Index, which means that they are among the 100 largest companies listed on the NSE.
The logic of the report probably remains valid anyway. These stocks are likely to be high-beta with respect to the bigger companies that are part of the Sensex/ Nifty set. They won't receive a great deal of retail interest and they are probably a little too large in terms of market cap to really benefit from the base effect. But they will grow faster than larger businesses in fundamental terms, assuming that the economy has turned the corner.
My reservations tie into the caveats made in the report itself. The report says, "An adverse electoral outcome and any delay in economic recovery are the key risks to the continuation of the mid-cap rally." To that, I would add the real possibility of a sharp rise in global crude and gas prices.
All three factors are genuine risks. The Crimean crisis is very likely to trigger volatility in global energy markets. The rupee could be destabilised if there is large-scale selling by FIIs. FII selling could easily happen if there is an unfavourable electoral outcome. Finally, "delays" in economic recovery are almost guaranteed since market expectations in this regard are unrealistic. The market is currently discounting only a magically favourable scenario: the BJP comes to power with a stable majority and very rapidly turns the economy around. Even if the BJP does come to power with a stable majority (and that is hardly guaranteed), it will probably take longer to turn the economy around than optimists expect.
However, these are all highly liquid stocks in their own right, and entries and exits are not a problem for the trader. Margin trading for leveraged gains is also easily enabled by the existence of stock futures.
The stocks in question could be high performers until May 15. On May 16, the election results will be declared and that will either reinforce uptrends or reverse them.
