Perhaps, this quote perfectly symbolizes investments into mid-cap stocks. These involve risks - stepping from the known (large caps, for which information is widely available) to the unknown (mid-caps, where information availability is low). While much has been talked about mid-cap stocks and the upside potential, lets understand what mid-caps actually mean and how should one go about investing in such stocks for the long-term?

Midcap or Mid-tier stocks? Market cap (or market capitalisation), put simply, is the product of the stock price and the number of stock shares issued. As such, a Company X with issued shares of 100 m and stock price of Rs 30 will have market cap of Rs 3,000 m (US$ 65 m). There are two factors here:

1. Share capital: The quantum of share capital varies sector-to-sector i.e. a smaller bank is likely to have a significantly larger capital base than a smaller company from the software sector because banks, by nature, need capital to grow. Take the example here. ING Vysya Bank's market capitalisation is Rs 5,999 (based on the market price on June 14th 2006) whereas the market capitalisation of Mangalam Cement is Rs 3,433 m (US$ 76 m). To put things in perspective, Mangalam Cement's turnover is Rs 3,090 m whereas the income from operations for ING Vysya Bank in FY06 was Rs 12,224 m. The nature of the business therefore, has a significant influence on the market capitalisation.

2. Stock price: Perhaps this is the most misunderstood part of the whole midcap hype. Stock markets are hardly 'perfect' and the current stock price of a company may or may not reflect the long-term value and therefore, the market capitalisation may be depressed. Secondly, there is a general perception that a stock trading at Rs 32 is a midcap (Ashok Leyland) as compared to a stock trading at Rs 730 (Tata Motors). What is important to focus in the case of midcap are 'valuations' and not the 'stock price'.

Given this backdrop, what actually is a midcap? Actually, there are no industry standards with respect to the classification of a midcaps per se. Given the NSE's categorization of mid-cap stocks (representing companies with market cap between Rs 750 m and Rs 7,500 m), ING Vysya is not a midcap stock, which in our view, is not true. So, it is in this context that investors should focus on the size of sector and the size of the company in the sector. This, one should compare with the largest in the sector to arrive at a conclusion. This is important because the size of some sectors is very small on a relative basis (like ceramics and paper). For instance, a company like Ballarpur Industries may be among the largest in the paper sector, but when compared with other sectors, it is a mid-tier company. Do not go by hearsay. Some basic level of research will reveal whether a company is really a midcap or not.

How do these differ from large & small caps? The answer to this question lies in understanding what is a large-cap! Take the case of a company like Gujarat Ambuja Cements. A company with a 20 year operating track record, professionally managed, regionally diversified cement manufacturing plants, revenues of over US$ 700 m and one of the most cost competitive producer of cement in the world. Compare this with Chettinad Cement - less than 1% of industry capacity, a regional player, revenues of just over US$ 100 m, just over 500 employees and yet to learn that size is important (capacity at 1.5 MT has been stagnant over the last five years). The table below compares three cement companies, which puts things in perspective.

Mid cap stocks are generally more risky than large cap stocks and less risky than small caps. It has been seen in the past that risk of failure decreases as companies grow in size. As they grow large, they enjoy better bargaining power with suppliers and customers (except companies in a regulated industry like power and fertilisers) and have stronger systems in place with respect to tackling competitive forces. On the contrary, as companies grow large in size, their growth gets saturated (due to a high base effect), thus under performing the much smaller mid-size companies, which have room to grow into large ones. As such, when considering an investment in a mid cap stock, you need to decide if the stock in question has the potential to grow into a larger company. If you are right in your analysis and follow your action of investing into the stock, you will have a successful investment.

When one invests in mid-caps for the long-term, he is participating in companies that will become blockbusters of tomorrow. A few years back, during the initial phase of the post-liberalisation period, there were a very few large cap companies listed on the Indian bourses. Currently, one would find more than 70 with US$ 1 bn and above in market cap (see adjacent chart). It is pertinent to note that the likes of Infosys were once a mid-tier company.

How to select good mid-caps? Unlike large caps, where there is no dearth of information, for mid-cap stocks, investors need to put in greater energies while doing their homework for identifying good long-term investment prospects - companies that will become much larger because of better opportunities, strong progress and robust growth.

As such, we outline some key guiding factors for selection of good companies from the mid-cap space.

1. Management: Unlike many of the larger companies, perhaps one of the major risks is that many of the smaller companies, barring exceptions, are family managed. Before investing, it is pertinent to understand the promoter group as a whole. The other things that we as a research house focus on is on the last five to ten year track record of the company, key accounting policies over the years, private placements of shares and how deep is the top-tier management.

2. Identify the leaders - Current and potential: Investors would do well to identify mid-cap companies that are leaders in their respective business operations. These companies are generally the larger ones from the mid-cap space and have better abilities to tide over volatilities that impact mid-size companies like them. When growth happens, these companies are much better equipped to consolidate their position and grow larger in size.

3. Identify niche and focused businesses: This is a very important consideration while researching mid-cap stocks. Operations in a niche space (like PLM for Geometric Software) help companies to shelve themselves from competition while providing differentiation benefits to customers. There are niche companies in commodity sectors as well (like iron ore manufacturers, cement manufacturers with a strong regional presence, focused manufacturers in textiles, FMCG companies with strong brands, MNC companies with a strong parent support). At the end of the day, the concerned company should have capabilities to tide over business cycles.

4. Liquidity: As we have seen in the past stock market cycles, it is important that a investor is aware of the liquidity situation i.e. what is the free-float (non-promoter holding), the last one year average volume and the last one-year average value of shares traded. The traded value is important because at times, the share price can give a distorted picture of the liquidity situation (in fact, many institutional investors focus more on value traded than volumes traded).

Last but not the least, have a cap for your midcap exposure, no matter how adventurous you are! By cap, we mean, as a percentage of the overall portfolio, midcap should not be more than 30% to 50%. This discipline is very critical for investors in general. Ultimately, Rome was not built in a day!

Source: EM

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Posted by toughiee on Wednesday, September 27, 2006 at 5:55 PM | Permalink