Investing in mid-cap is likely to be a roller-coaster ride in 2019: Experts

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In a growth market like India, chasing outperformance often sends investors looking for ideas in the mid- and small-cap space. However, as mid-caps end 2018 with their worst seven-year performance; fund managers' ability to beat benchmarks (also called alpha) is facing some serious questions.

While 2019 is likely to remain volatile, fund managers say the correction opens up opportunities as quality names had run up into ‘overvalued’ territory.  

In 2018, the Nifty Midcap 100 saw a 16 per cent fall after recouping some of its losses. In the same period, the Nifty 50 managed to keep its head just above water with gains of around three per cent.

“The correction in valuations is a positive sign. Otherwise, the mid- and small-cap space was looking quite expensive,” says Vinit Sambre, head (equities) of DSP Investment Managers.

In September, DSP Mutual Fund (MF) re-opened its small-cap fund for fresh subscriptions. The fund house cited fall in valuations and signs of earnings recovery as reasons for re-opening the fund. DSP MF along with some of the other fund houses had put caps on investor inflows as deploying fresh funds had become challenging due to surge in valuations. 

At the beginning of the year, Nifty Midcap 100 was trading at a one-year forward price-to-earnings multiple of 28.7-times, 52 per cent premium to Nifty 50. 

“Certain mid-caps are now trading at 10-15 per cent discount to large-cap peers in the same sector. The discount may vary across sectors,” says Mahesh Patil, co-chief investment officer of Aditya Birla Sun Life MF.

Fund managers feel the time is ripe to look for opportunities in beaten-down sectors. 

Non-banking financial companies (NBFCs) — which were caught off-guard due to liquidity squeeze post-IL&FS default — have piqued Sambre’s interest. “While NBFCs are going through a tough phase, those with niche capabilities and stronger balance sheets can offer good opportunities. Some housing finance companies can also make a comeback once the government gives the much-needed push for the real estate sector,” he says.

Sambre adds some of the corporate-oriented private banks can see big delta in earnings as their credit costs and asset quality improve.

Other themes that fund managers are closely watching include building materials and select pharma names as they expect US pricing pressure to end soon. 

For now most fund managers are keeping away from expensive stocks and are looking for stocks where downside might be limited. They say consumer discretionary and non-discretionary plays will only be interesting once valuations correct to reasonable levels.

“In the last four-five years, mid-cap names from sectors such as retail, auto, and retail banks have largely driven the rally. Meanwhile, utilities, cements and hotels have lagged behind. We are overweight on cyclicals like capital goods, real-estate and cements,” says Sailesh Raj Bhan, deputy chief investment officer of Reliance MF. Some of the names are trading at reasonable discount to their replacement costs, he adds. These companies are sitting on strong operating leverage and their downside may be limited. 

Domestic macros have also lent a helping hand. “One-year back, the macro situation seemed bleak with oil prices shoring up. Things have improved as oil prices have cooled down. This bodes well for current-account deficit and the interest-rate scenario,” Bhan adds.

Brent crude oil has fallen 39 per cent from its recent peak of $86 a barrel.

“Softening of commodity prices is good news for mid-caps that rely on energy, metals or polymers for their production needs,” says S Krishna Kumar, chief investment officer of Sundaram MF.

However, volatility is likely to remain a recurring feature of markets at least till the general elections and mid-caps might have to bear the brunt.

“There are both domestic and global events that can add to volatility. There is talk of global slowdown and US-China trade wars. Markets could face a lot of election-related noise in the run-up to elections. In such an environment, some of the expensive names may give away their gains,” Sambre says. 

The last 10-year data suggests mid-caps tend to bounce back after large draw-downs. In 2011, the Nifty Midcap was down 31 per cent. For the next six years, it compounded at an annual rate of 23 per cent. While there is enough to hope for and plenty of stock ideas keeping fund managers excited; investing in mid-cap is likely to be a roller-coaster ride in 2019.  

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