Ten things to monitor after you have invested in mid-cap stocks

| Published on 14th March 2019 | 888

Back in 1997, Havells was a largely unknown company in the electrical goods space.Had someone invested Rs 10,000 in Havells in 1997, it would be worth Rs 3.50 crore today. Of course, that would have been hard to envisage back in 1997 but that is what mid-cap stories are all about. You buy them for big returns when they eventually transform into large caps. Over the last 25 years, we have seen stocks like Lupin,
Eicher, TTK Prestige, Avanti Feeds, Ajanta Pharma etc create big value as they transformed from small caps into mid cap and then into large caps.

However, if you had stayed invested in mid caps through 2018, you would have realized the risks of mid-cap stocks. In a year when the Nifty was up by 4 per cent, the mid-caps were down by 16 per cent and the small caps were down by 26 per cent. But the individual damage to most stocks was in excess of 50 per cent. How do you reconcile this dichotomy between the returns potential and the risk of mid-cap stocks?

Checklist to monitor your mid-cap stocks:

  • Past performance may not always be revealing but it is your best bet against the uncertainty surrounding mid-cap stocks. A consistent track record is the acid test of any mid-cap stock and here we refer to consistent performance over the last 4-5 years.
  • Check for vulnerability to macros.For example, mid-cap banks and NBFCs are vulnerable to NPAs and interest rate movements. Mid-cap auto ancillaries are vulnerable to global demand and auto trend shifts. Mid-cap metals are more prone to succumb under excess capacity. Keep a constant on these risk factors.
  • Avoid comparing the mid-cap stocks with the Nifty or Sensex on a continuous basis.You are in mid caps for the alpha and not for the beta. You should look at mid caps ideally as absolute return stocks rather than as relative benchmarking stocks. Of course, you can benchmark to the peer group because even mid cap indices tend to be heterogeneous and hence non-representative.
  • Liquidity is the Holy Grail for mid-cap stocks. What you need to focus on is that you can exit the stock you are holding without too much price damage. Be cautious on midcaps where mutual funds or proprietary traders have bought huge quantities. They are vulnerable to quick selling in the markets and can damage value quite fast.
  • Pledged shares have come under a lot of scrutiniesin the recent past, especially in the case of mid-cap companies. Ideally, avoid companies where more than 50 per cent of the promoter stake is pledged. Such shares become vulnerable if the price corrects. If the promoters are unable to bring in the margins, it leads to the financers dumping these shares in the market. That is a situation that is best avoided.
  • Define mid caps as a percentage of your equity portfolio and stick to that exposure.Keep booking out and shifting to large caps as the targets are met. Here is how it works.For example, if based on your risk appetite you decide to have 30 per cent of your equity allocation to mid-caps then stick to it. Keep a 5 per cent leeway and whenever the mid-cap proportion crosses 35 per cent, bring it back to the original levels. This can also ensure that profits are monetized and booked at regular intervals.
  • Focus on management and corporate governance.You need management with a long-term commitment to shareholders. In the case of mid-caps, you need to be doubly careful. Management quality is best judged by the standards of corporate governance followed. Keep a tab on auditor reports, analyst reports for grey areas. Do regular channel checks on your mid-cap stocks for problem areas. That is the key.
  • When it comes to mid caps, monitoring risk becomes a lot more important than managing returns.Here, we measure risk with volatility. Evaluate mid-cap stocks based on risk-adjusted returns. A mid-cap stock giving 20% returns with 15% standard deviation is better than a stock giving 22% returns with 35% standard deviation. If you manage the risks, the returns will automatically follow in mid-caps.
  • Give more credence to how the mid-caps perform in times of Nifty downturns than in upturns.This is important for 3 reasons. Firstly, mid-cap stocks tend to outperform in a good market and hence the actual stock quality can get hidden under a larger wave. A down market gives a much clearer picture. Secondly, in a down market, the ability of the company management to handle risk becomes more critical and that is the true test of a mid-cap fund. Finally, it is the bad times that separate the wheat from the chaff.
  • Finally, keep a tab on regulatory issues as mid-cap stocks are most vulnerable to regulatory shifts. For example, back in 2005 when the SEBI initiated an investigation into penny stocks, the mid-caps were the worst affected. In 2018, three SEBI announcements had a negative impact on mid-cap stocks. The introduction of tax on long term capital gains, reclassification of mutual fund holdings and the imposition of additional special margins (ASM); all had a big negative impact on mid-cap stocks. By default, mid-caps tend to be vulnerable to regulatory developments.

Use this 10-point checklist to monitor your mid-cap portfolio in a smart and systematic
manner.

The Article has been authored by Mr Amarjeet Maurya (AVP – Mid Caps, Angel
Broking),& the article appeared on 11th March, 2019 on the following website –
www.business-standard.com.