If large-caps are the bread and butter of fund portfolios, midcap stocks are the jam. Approximately one-third of the consolidated corpus of funds is invested in mid-caps and this segment produces high returns relative to its representation.
India is a growth economy where large-cap indices such as the Sensex have yielded compounded returns of 33% in the past five years. Mid-caps have done even better - the BSE 500 has a five-year compounded return of 39% and of course, many individual stocks (and funds) have beaten the benchmark. In fact, quite a few of the mid-caps of the early 2000s are now largecaps simply by dint of generating really fast growth.
Mid-caps benefit from the "Goldilocks effect". They are the perfect size - not so small that they cannot absorb hefty institutional investments and not so large that they can't grow quickly. Also, midcaps generally have track records and that makes it easier for analysts to assess the business potential and quality of management.
The top 10 in this category are all pushing the envelope in terms of graduating to large-cap status. The average market cap of the top 10 mid-caps is in the range of about Rs 5,100 crore.
The holdings in this segment of the market do show a herd effect though it is less marked than in the large-caps. Every company in the list of top 10 mid-caps is held by a minimum of 36 different funds and some are held by 50 or more.
Given the fact that FIIs are also heavily invested in the mid-cap universe, many stocks now have little free-floating equity. In Amtek, for instance, over 92% of the equity capital is held by a combination of the promoters (33.7%), FIIs (42.4%) and funds (16.2%). Thermax (80%), Cummins (79.5%) and United Phosphorus (78.25%) are also short of float. The lack of stock supply means that prices are further pushed up in bull runs.
Several top 10 mid-caps are leaders in their specific business segments. Tata Tea, Indian Hotels and United Phosphorus are all sector leaders. Thermax, Cummins, Amtek Auto and IVRCL are dominant in specific areas and India Cements is a regional leader.
Apart from IVRCL Infrastructure, all these companies were around before the 1991 liberalisation. However the real growth came only after the restrictive aspects of licencing were removed. In the case of IVRCL, an entirely new business segment came to life after the infrastructure sector was thrown open to private players.
The two A.V. Birla companies in the list are odd throwbacks to the licence raj. Century Textiles is an unusual case. It used to be a giant of the Sensex that fell from grace.
Aditya Birla Nuvo (ABN) seems like an old-style conglomerate at first sight. It dabbles in businesses as diverse as IT, ITeS, telecom services, fertilisers, viscose filament yarn production and insurance. It is, however, managed in a modern style. The clubbing together of the businesses was deliberately brought about through mergers and inter-group restructurings. Each division remains a strategic business unit; the entire outfit is controlled through a board.
Most of these companies are expensive in terms of pure price earnings. However, when we control and sort for growth through the use of the PEG ratio, most stocks seem to be quite cheap in relation to their current growth rates.
The lowest five are very comfortably priced in terms of PEG. India Cements' low PEG is misleading because the company turned around in 2005-6 with a dramatic 2,075% growth in earnings per share over 2004-5. Obviously that is unsustainable.
EPS growth rates were also high for United Phosphorus, Tata Tea, Thermax (after adjusting for a 5:1 split) and Indian Hotels but these companies may maintain their current scorching growth with a question mark in the short term over Tata Tea, given its enormous overseas acquisitions.
IVRCL is definitely overpriced with respect to 2005-6 growth rates but analysts expect the growth rate to rise from the present 32% to a minimum of over 50%. Cummins is mildly overpriced as is ABN.
The real question mark arises over Century, which saw an earnings slowdown in 2005-6. But the first half of 2006-7 shows an improvement of 170% in earnings growth against the first half of 2005-6 and, if that is sustained it will pull the PEG back into line and instead turn Century into quite a low PEG stock at around 0.33.
Our take is that a mid-cap portfolio still combines a fairly high degree of safety with the promise of higher returns. It isn't as staid as a large-cap exposure; nor is it as dangerousas a small-cap holding.