Six years of underperformance
Over the past six years, mid-cap companies have significantly lagged large-caps, with the BSE Mid-Cap index underperforming the BSE Sensex by 4,000 basis points. Investors have become risk averse from 2008, preferring larger companies to their smaller counterparts. This shift in investors focus from small to big was driven by concerns over high leverage and poor corporate governance among mid-cap companies.
Indeed, while the average debt-to-equity of the 50 companies in the NSE Nifty Index is currently around 72%, the BSE-500 Index constituent companies, excluding those that are also in the Nifty, have an average debt-to-equity of almost 130%. Although mid-cap companies in the long-term deliver better returns than large-cap, they typically tend to underperform during down cycles.
The case for investing in midcap stocks
The mid-cap index has severely underperformed the large-cap index in the past few years, resulting in a high valuation gap. Currently, the mid-cap index is trading at a 39% discount to the large-cap index. Although mid-cap companies offer better returns in the long term with a slightly higher level of risk and there is wide valuation differential between mid-caps and large-caps, we expect large-cap stocks to outperform in the near term. In our view, 2014 is likely to continue to be painful for smaller stocks as uncertainty over QE tapering and the coming general elections keep investors biased towards low beta trade.
Time for a reversal?
Our economist believes the RBI is likely to raise the policy rate further in 2014, as inflation pressures remain. Given that leverage rises quite dramatically from-large-caps to mid-caps, this hardly makes the case for investing in mid-caps compelling. On the other hand, foreign institutional investor (FII) holdings in mid-cap stocks have fallen consistently over the last six years. QE tapering by the Fed is also likely to have a bearing on capital flows into emerging markets and it is difficult to envisage excessive inflows into Indian equities in such an environment. In our view, though their valuation gap with large-caps has widened, mid-caps lack material fundamental catalysts to stage a broad-based turnaround.
Three key themes for 2014
Investors who choose to look at mid-caps in 2014 should adopt a selective approach based on the following three key themes:
(i) Relative insulation from leverage-related stress. Given our expectation that policy rates will remain high in 2014 on the back of sticky inflation, we would be cautious on most names with high leverage. Our equity analysts highlight two pharmaceutical companies, Ipca Laboratories Ltd and
* Ipca Lab (CMP: R701, OW and TP: R805): US growth has become a reality. Post the USFDAs approval of SEZ Indore facility, Ipca expects US sales to ramp up significantly with the first few launches due in Q4FY14, along with two new approvals and site transfers for one-two old products. Ipcas export formulations have bounced back strongly post the recent slowdown in a few markets due to the implementation of a new tracking system. Our analysts expect export formulations to outgrow domestic formulations sales with a CAGR of c24% (against 14% for India) over the FY12-15e.
* Torrent Pharma (CMP: R469, OW and TP: R537): Despite the overall market slowdown due to new pricing policy and trade disruptions, Torrents India formulations sales remain strong on the back of a healthy product mix with c65% its product portfolio for chronic therapies like cardiac, CNS and diabetes, (Q2FY14 sales growth of 14% versus market growth of 3%). The US contributes c12% of total company sales, and is one of the fastest growing markets for Torrent. Despite being a late entrant in the US market in FY06, Torrent had a healthy product launch rate of five-six products per year and has a decent pipeline with 24 pending ANDAs. Our analysts expect the US to remain a strong source of growth for the company, led by new launches and increasing market share in existing products.
(ii) Uptick in utilisation: Our economists expect the Indian economy to bottom in FY14 and slowly resume a growth trajectory. While execution related risks in corporate India remain elevated, a number of companies have completed their capital spending programmes over recent years and are poised to see a recovery in cash flow. In terms of the utilisation theme, our equity analysts believe that
Bharat Forge Ltd (which is benefiting from a recovery in both the local and overseas markets) and ILFS are key stocks to play this theme. ILFS does have a significant degree of leverage but most of the leverage is structured around toll roads and annuity incomes.
* Bharat Forge ( CMP: R320, OW and TP: R380): BFL is one of the largest forging companies in the world and, as a standalone entity, enjoys cost leadership and a track record of efficient operations. Our analysts believe the company has one of the best management teams in the engineering space and its focus on managing its human resources is one of the best in the industry, resulting in higher efficiencies and better cost management. Further, its ability to source raw materials from its sister companies also enables it to manage costs better.
* IL&FS Transportation Networks Ltd ( CMP: R138, OW and TP: R172): ILFT is poised to make seven projects operational in 2014e. Three of these will be among ILFTs top four assets; it has 26 road assets in total. With the launch of these seven projects, our analysts expect ILFTs average daily cash collection to increase threefold to around R60m by FY15e. This will likely ease investors main concern about the company and the sectornamely, potential delays in cash flow generationlimiting developers ability to cut leverage.
(iii) Strong earnings momentum with reasonable valuations: On the theme of strong growth at reasonable valuations, our analysts highlight three names in the mid-cap space: (i) LIC Housing which is in the resilient mortgage finance business, (ii) Power Trading Corp, and (iii) Prestige Estates.
* Prestige Estates Projects Ltd (CMP: R157, OW(V) and TP: R190): Prestige maintains a very high level of corporate governance/disclosure standards and has been able to meet its guidance successfully since listing. Despite some weakness in key markets like Bangalore, its sales momentum continues apace, driven by strong presales and a strong brand. The company has a diversified product mix ranging from mid-market to premium offerings in the residential segment. It has also it has nurtured a wide client base for its commercial projects. The company has high cash flow visibility based only on the projects that are currently under development.
* Power Trading Corp (CMP: R61, OW and TP: R78): The company has reported better-than-expected growth in volumes in H1, up 20% y-o-y in a tough market and is likely to beat its own guidance of more than 32 bn units for FY14 (growth of 12% y-o-y). The outlook has improved significantly in the last few months with (i) higher visibility in long term volumes, which is a key driver of growth, (ii) de-risking the tolling business with margins protected and (iii) much awaited receipt of old dues from Uttar Pradesh state utility of R7.78 bn in October 2013.
* LIC Housing Finance Ltd (CMP: R215, OW and TP: R253): While the overall slowdown in the economy has plagued the financial services sector in the past few quarters, the housing finance sector has remained largely immune, making stocks such as LIC Housing Finance a stand out in this space. Improving margins, 18-20% loan growth over FY14-FY16e and stable asset quality should drive the stocks outperformance.