Dates for this year’s biggest event, Lok Sabha elections, have been announced. It’s 2014 again for many political pundits. In a stroke of sheer luck, midcap and smallcap stocks are also poised at 2014 lows, from where they staged a huge comeback as Narendra Modi-led BJP won the historic mandate five years ago. Early signs of a revival for smallcaps and midcaps were seen two months ago and our cover story dated January 16 ‘Is It Time To Again Buy Small, Midcap Stocks?’ shed light on the trend. Since then, midcap and smallcap stocks have got an increasing share of the spotlight, as largecap stocks lost steam. In the last one month alone, mid and smallcap indices have gained between 2 and 5 per cent even as the Sensex fell 1 per cent. Over 150 stocks in smallcap index rose 10-40 per cent in the four-day period ended March 8, indicating a full-blown re-rating. Read on to know more.
2014 was not an ordinary year. Markets regained their form that year after the elections ushered a new government with a decisive mandate. Five years down the line, things seem to have changed little. The relative valuation of midcaps versus largecaps is at a historically low level. The 7-day moving average is at 2014 levels. Also, the rolling 1-year return difference between midcap and largecaps are at a historical extreme of minus 22 per cent compared to an average of 4.4 per cent. All these stats indicate that valuations are compelling at these levels for a revival in the performance of midcaps. This may be especially true for high-quality midcaps which have taken quite a beating and are good bets for anybody investing for the long-term. Smallcaps are a bigger universe, and it is important that investors really do a lot of research before betting big on a stock.
For a full-blow re-rating of midcap and smallcaps, all that is needed now are solid earnings. In 2014, it was about new hope. In 2019, it is about execution. Thanks to an expected normal monsoon, expect benign input prices (including crude oil and commodities), a solid consumption outlook is expected to lead to earnings recovery in FY’20. The pick-up in earnings should help midcaps. The Nifty has so far significantly outperformed the midcap index since December 2017. This staid underperformance of midcaps can largely be attributed to unsustainable valuation premium to largecaps, macro headwinds and liquidity issues.
If you look at just data, there are definitely encouraging signals. As per historical data, the peak-to-bottom correction trends suggest midcap correction is over. According to numbers, over the last 12-13 years, the correction in midcaps from the peak to the bottom has been much higher relative to largecaps. This is because midcaps (and smallcaps) are more volatile compared to largecaps. Now, with hitherto struggling midcaps starting to do well, things are expected to change for the better. Certain sectors have badly hit midcaps as a group. For example, the unusual and lingering drag from the PSU banks on the midcap index would soon be a thing of the past, as the government lenders are nursed back to health. Another sector that is expected to do well is metals and mining, who have previously dragged down midcaps.
The last two weeks have seen mid and smallcaps rally. If the tide has turned in favour of small and midcaps, there are a set of people/investors who can benefit handsomely. The pace of turnaround is not surprising as the previous one year saw small and midcap stocks getting beaten down badly. Many had completely written them off. But, they are rising like a phoenix. Of course in the near term, the market direction will be a function of the general elections and the consequent political outcome. Until then, it will be an era of high volatility.
Retail investors wanting to play the midcap and smallcap themes should adopt a safety first strategy. Here is what you do. Firstly, only invest in those midcap and smallcap stocks that have a daily trading turnover of $1 million. This will ensure you are not stuck in illiquid stocks. Secondly, go for quality stocks than small unknown and untested companies. Three, it is better to take the mutual fund and ULIP way when it comes to directly investing in midcap and smallcaps. Do SIP in funds with at least 5-7 year track record. The SIP investment period should be for at least 10 years so that you can gain the full cycle benefits.
The author is a financial journalist with 14 years of experience