A number of investors and distributors have been calling me up over the last few days asking whether we should sell out all of our holdings of mid caps and get into large caps as only large caps are moving up in the market rally and mid caps are hardly moving and have moved up less than half that of large caps over the last three weeks rally.
In my view the current market scenario where the economic outlook is bottoming out not only in India but also globally, the interest rate scenario is much more benign and more importantly huge amounts of money is being pumped in by monetary authorities and governments globally, a stage is being set for a huge deluge of liquidity into risky assets which include emerging market assets, commodities etc over the next two to three years. Under this scenario the next two to three months will be an ideal time to pick up high quality mid caps with a two to three year outlook. There are 100’s of mid caps today in the markets which can give 100% return over this time period.
Mid caps today trade at a sharp discount to large caps, despite some of them having a much greater visibility on future growth. There are a large number of mid caps whose market value is not much greater than the cash they have ( although the vast majority now doubts cash holdings after the Satyam episode). Companies that used to trade at 25x price to earning ratio today trade at 2-4x price earning ratio.
The ideal time to buy mid caps is when most investors are negative on them, there is low visibility for the near term, they are extremely illiquid and when they can be bought with very low impact cost ( for example in today’s scenario lot of FII’s are willing to sell their mid caps at discounts rather than a premium which is required during bullish market conditions). I believe all the conditions are satisfied at this point of time. This is also a time period where return from mid cap stocks over the next two years might be high as lot of these companies might not dilute their equity in the near term and as such all the benefits of a cycle improvement will come to exisiting shareholders.
Typically two to three years after the start of a new up move a majority of smaller companies start diversifying and raising equity which in most cases is counterproductive to existing shareholders. As such the time to buy mid caps is not at the end of a new up move where there is huge euphoria and most companies believe that they have got strong visibility of future growth. The ideal time is when most managements also become sceptical and pessimistic on future growth and that scenario exists today.
However, on the other hand mid cap investing requires much more due diligence and the ability to evaluate the managements and business models properly whereas when one is investing into large caps it is more a top down market and sectoral call. To that extent a large number of retail investors might not be able to evaluate smaller companies properly.
On a broad basis i believe that mid caps will outperform large caps by nearly 100% over a three year holding period from where we are placed today. Most investors will continue to focus on large caps for a large part of time when the new bull market would have already started and that will provide opportunity for discerning investors to pick out high quality mid caps.
I do not mean to say here that investors should not invest in large caps, there are a huge number of large caps that are likely to perform extraordinarily well as the economy revives and have got very strong cash flow which will help them grow faster than others in the first 12-18 months of a new bull market where raising fresh equity is not very easy. But discounting mid caps as junk is not the right strategy as ultimately it is high quality mid cap companies which will become the large caps in the next upcycle.
In a nutshell i would say that that the key to making money in mid cap stocks is to buy them when they are very cheap, illiquid and when no one is looking at them. Eventually as the companies start delivering results consistently quarter on quarter more and more people start looking at these stocks and the liquidity builds up. But since these are mid caps with a limited floating market cap the returns can be substantial.
I would like readers to kindly advise me on what subjects i should be writing on so that i can write on issues which are of interest to you.
