Small and Middling Opportunities

 Tanvi Varma        Print Edition: Apr 1, 2012

Stocks of mid-cap and smallcap companies, which bore most of the brunt of last year's market slowdown, look ready for a turnaround in 2012.

Between January 2011 and January 2012, mid-cap and small-cap indices slumped 15 per cent and 24 per cent respectively, compared to Sensex's six per cent fall. While the profit after tax (PAT) growth of companies on the Nifty and the Sensex was 5.9 per cent and 6.6 per cent respectively, in the second quarter of 2011/12, mid-caps grew only 3.3 per cent.

Swapnil Pawar, Chief Investment Officer, Karvy Private Wealth, says when the going gets tough, small-cap and mid-cap companies suffer the most, due to their low pricing power and weak balance sheets. Deterioration in their profi tability is steeper, which is reflected in their stock prices. In the last three years, when stock markets faced a lot of uncertainty starting with the global crisis of 2008, the mid-cap and small-cap category underperformed the broader market.

According to a report by Emkay Global Financial Services, between the first quarter of 2008/09 and the second quarter of 2011/12 - that is, after the 2008 slowdown - the average PAT growth of companies on the National Stock Exchange Mid Cap Index was 11 per cent. In comparison, just before, in the period between the third quarter of 2006/07 and the fourth quarter of 2007/08 it was 14 per cent.

"The two major differences between large-caps and mid-caps/small-caps are the impact of interest cost and falling demand on margins," says Ravi Shenoy, Assistant Vice President, Product Development, Motilal Oswal Securities.

The Reserve Bank of India has increased interest rates 13 times since March 2010 to control inflation. This has increased the cost of funds for consumers and companies, and hit demand. While large companies can still access funds at a relatively lower cost due to their sheer size, the mid-cap and small-cap companies cannot.

Three mid-cap/small-cap companies whose stock movement is worth watching
"Second-rung companies are seeing extended working capital cycles due to pressure from large companies and higher debt cost which banks find easier to pass on to them," says Shenoy. Further, consumers stick more with large brands unless the price difference provided by the smaller one is signifi cant.

"To add to it, the fall in operating profit has been magnifi ed at the profi t level due to ballooning interest payments," he adds. This becomes a vicious cycle with market price to earning (P/E), falling. The P/E contraction in mid-cap\small-cap stocks is larger as investors prefer the relative safety of large-caps.

If we look at specific mid-cap and smallcap stocks, those in real estate and infrastructure sectors have been hit the most. The main problem has been high interest rates. "Issues of environmental clearances and land acquisition have added to the problems," says Pawar.

Real estate company HDIL saw net sales and PAT fall 60 per cent and 73 per cent in the September 2011/12 quarter. Its stock has fallen 70 per cent in the last one year. IVRCL saw fl at growth in net sales in the same quarter while its profi t fell from Rs 23 crore to Rs 8 crore. Similarly, engineering company Voltas reported a 60 per cent fall in profi t.

A.K. Prabhakar, Senior Vice President, Equity Research, at financial services firm Anand Rathi, adds capital goods, metals, airlines, and polyfilms to the sectors that have taken a beating, mainly due to worries over corporate governance, rising input costs, high debt, falling orders and execution delays.

However, some mid-cap and small-cap stocks have done well in the same quarter. These include stocks of a number of information technology companies such as Mindtree, which posted an adjusted profit growth of 135 per cent, followed by Tech Mahindra, which expanded profit by 59 per cent, according to a report by Emkay Global.

Pharmaceutical stocks such as IPCA Labs and Jubilant Life Sciences showed adjusted PAT growth of 61 per cent and 55 per cent respectively, compared to a year ago. Pawar says if the sector is growing fast overall, some mid-cap companies in the sector may grow fast as well.

Average profit after tax growth of mid-cap companies has been the lowest
This explains the strong performance of mid-rung IT companies - which have benefited from rupee depreciation - and Tier-II pharmaceutical firms. Experts say the biggest driver of stock market returns in the mid-cap space is how quickly a company can scale up and become a significant player. That is why it is important to pick and choose specific stocks and not follow a sectoral trend.

Data suggests that when the markets bounce back, mid-cap and small-cap indices rise faster than the overall market. This was clear when the markets gained strength between December 2008 and December 2010. During the period, the Sensex went up by 113 per cent, while BSE mid-cap and small-cap indices rose 141 per cent and 163 per cent, respectively.

Pawar of Karvy Private Wealth says once the economy normalises, mid-cap and small-cap stocks will again start delivering better returns than the large-caps.

Experts feel investors should put their faith in companies that are aspiring leaders in their fields. Pawar adds that companies in the nonbanking finance company space, health care and engineering sectors look attractive at current valuations. Further, investors need to look at the quality and stability of a company's cash flows.

"Positive operating cash flows and cumulative free cash flows over the last few years are important indicators of a strong business model," says Shenoy of Motilal Oswal Securities.

BUYING TIPS

  • Go for companies with low debt ratio (preferably less than one)
  • A high interest coverage ratio (above 3x) and a high return on equity are big advantages
  • Avoid companies with huge liabilities in the form of foreign currency convertible bonds/external commercial borrowings
  • Look at the quality of the management, its governance standards and how investor-friendly the company is
  • Mid-cap and small-cap companies can be future market leaders, so be patient with your investments
The dividend record of companies should also be looked at - they point to the management's willingness to reward shareholders. Further, there are quantitative parameters that affect the performance of a stock.

Prabhakar says investors should go for a low debt ratio, a high interest coverage ratio, a high return on equity, and also see if the company has any liabilities in the form of foreign currency convertible bonds. Besides, the quality of the management, governance standards and how investor-friendly the company is also matters, he adds.

Mid-cap and small-cap companies can be future leaders, so investors should be patient with their investments. Over the next two to three quarters, slowing top-line growth and less-than-expected easing of commodity prices could continue to keep margins and earnings under pressure. Shenoy says midcap and small-cap stocks are like wine and give the best results when owned for long periods.

However, business fundamentals can change any time. Investors have to be nimble-footed and ready to cut losses if estimates go haywire. "Entry during panic adds to the returns from equities and this is more true for mid-caps and small-caps," says Shenoy.

If you have the expertise and time to track these stocks, you can invest directly. If you want to passively partake in the growth of these companies, you can invest in an exchange-traded fund or an index fund, like the one offered by Motilal Oswal Mutual Fund, which replicates the holdings of the CNX Mid Cap index.

If you want active fund management, there are a large number of mid-cap and small-cap funds offered by mutual fund houses. Choose a fund with a good pedigree and record.

Courtesy: Money Today

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