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Analyzing the Case for Mid & Small Caps

Aug 6, 2018

Investors face two key issues today. One, with large caps delivering well, does one need to bother with mid caps and small caps? Two, with markets running up to new all time highs, is this a good time to invest?

Is Owning Mid and Small Caps Worth the Risk?

Following a period of unique mayhem over the past few months, with large caps behaving far better than mid caps, investors would certainly not be faulted for wondering if they even need to bother with mid and small caps. Investors have basked in the safety of large caps this past year, as the divergence between large cap and mid / small cap has never been starker in the past 20 years.

We share data below on large, mid and small cap returns by listing peak to trough returns going back to 2000, or roughly 18 years of data. Some key findings:

  • Mid caps consistently outperform large caps on up cycles. Interestingly, mid caps outperformed large caps during the sell-off in 2015 as well, but have fallen more than large caps recently. However, the data unequivocably demonstrates that the risk reward for high return seeking investors clearly favors mid & small caps.
  • The small cap index underperformed the mid cap index in the 2000s rally by a wide margin. The case for owning the small cap index is unclear, as it barely outperforms the mid cap index, and sometimes underperforms on up cycles, but consistently falls sharply.
  • With respect to the current cycle, despite the “crash” in mid-caps, the mid cap index is still outperforming the Nifty 50 since the Dec 2016 trough.

Over 18 Years of Peak to Trough Returns Data, Mid & Small Consistently Outperform Nifty 50 in Up Cycles…
…Adjusted for Volatility, the Sweet Spot Remains Mid Caps

Over 18 Years of Peak to Trough Returns Data, Mid & Small Consistently Outperform Nifty 50 in Up Cycles

Note: 2001 Trough to 2007 Peak data is calibrated to a larger Y-axis scale. Last column is 2016 Trough to Present, which is an additional cut.

The Nifty 50 – Peak to Trough Returns Since 2000

The Nifty 50 – Peak to Trough Returns Since 2000

The Mid Cap 100 Index – Peak to Trough Returns Since 2001

TThe Mid Cap 100 Index – Peak to Trough Returns Since 2001

The Small Cap 100 Index – Peak to Trough Returns Since 2004

The Small Cap 100 Index – Peak to Trough Returns Since 2004

One final point that corroborates our view. The 5 year average returns of mid cap mutual funds is higher than the Nifty 50 index return by 11% per annum. Small caps fund beat the Nifty 50 by an even larger 14% per annum. The analysis can be extended to earnings growth and it would further support the story: Mid caps deliver stronger earnings growth, albeit more volatile, and higher than the Nifty 50.

Is It a Good Time to Enter Equities?

Let’s look at the worst case scenario first. Let’s assume that we get it wrong, and you enter the market at the peak. The track record in the charts shows the returns from peak investments. Even if an investor bought the Nifty at the peak of 2007, they still made 98% in mid caps, and 81% from just owning the Nifty 50. Fund managers would have delivered much higher returns.

If an investor bought the 2010 peak, they again doubled their money at 97% for mid caps, and 80% for the Nifty. And even if they bought the peak in 2015, they’re up 36% in mid caps, and up 27% in the Nifty 50. We address the broader issue of our equity outlook in the Outlook section below.

In Portfolio Management theory parlance, owning mid caps and small caps extends the efficient frontier higher and allows investors to shoot for higher returns while accepting incrementally higher volatility. Clearly the appropriate approach is to own a diversified combination of mid, large and small. The percentages can vary according to individual appetite.

Sales Are Up an Impressive 19.7% for the Nifty 50 and 16.5% for the CNX 500 So Far…
… But Net Profits Have Suffered From Rising Interest Costs

Sales Are Up an Impressive 19.7% for the Nifty 50 and 16.5% for the CNX 500 So Far

However, Adjusting for Large Losses in Idea Cellular, Tata Motors, and Central Bank of India… …Nifty Sales Go Up to 20.7%, CNX 500 Sales Up 17.6%, And PAT Goes Up to 11.1% and 14.9% Respectively

However, Adjusting for Large Losses in Idea Cellular, Tata Motors, and Central Bank of Indiar

58% of Companies Have Delivered Double Digit Sales Growth in the CNX 500 So Far

The Trailing P/E in the Nifty 50 Remains Elevated

Upgrades for Nifty 50 Have Improved Marginally

Outlook

Equities

Disposable Incomes to Decline Moderately on Rising EMIs

With the rise in repo rates, the cost of funds for banks and housing finance companies has risen as well, but rising rates are being passed on to the consumer. HDFC has raised its lending rates thrice this year. With the latest hike, lending rates have gone up by 45 bps. RBI, on the other hand, over the last two policy meetings, has hiked rates by 50 bps. On a Rs 40 lakh, 15 year loan at an interest rate of 8.6%, the latest 20 bps points hike would raise EMIs by Rs 500 approximately.

Consumer Sentiment at Record Highs

Consumer sentiment in India rose to record high in July as respondents were bullish about future prospects for both business conditions and household finances, says the Genesis India Consumer Indicator. GICI, a monthly indicator tracking consumer sentiment pan India across personal finances, business conditions and buying conditions, rose to 62.44 in July from 60 in June.

GST Collections Rising

GST collections rose to Rs 96,483 crore in July, from Rs 95,610 crore the previous month, on improved compliance post implementation of the e-way bill. 66 lakh businesses filed returns last month, making it the highest number of monthly GSTR-3B filings since GST rollout.

Government Is Priming the Pump

M3 is up 10.2%, Currency in circulation is up 24%, Credit for Services is up 23.9%, Cement and Coal production are up 13% and 11.5% respectively. Surprisingly, even petrol and diesel consumption have risen strongly, up 13% – 16%. Central government expenditures have picked up after a summer lull, up 30% over the past two months. The government looks to be priming the pump, and that bodes well for equities.

We’re All Domestic Inflows Watchers Now

The media has been blaring that June DI flows declined, as well they would have. June was a painful month for most investors, particularly those in mid and small caps. With the market having a strong July, we expect flows to normalize in August and looking ahead.

No Change to Our Outlook

In May 2018, we ’ve had a view that equities look better positioned than they have in some time now. (See “Change – In Macro and Equity Investments”, May 25, 2018). Earnings growth is coming through, even at the index level. Crude oil is declining, rural continues to recover and the consumer is showing strength. Capacity utilization is rising – to 75% – and at 80% we expect to start seeing new capacity private investments.

Macro fears are being addressed slowly but surely. Tax collections have risen, relieving pressure on the fiscal deficit. Crude oil prices have declined. Trade war rhetoric has not impacted India and has led to a sell off in commodities, which helps commodity importers. The 10 year g-sec has stabilized as well.

The market historically spends a fair amount of time hitting new highs. The issue is investor perceptions, which haven’t caught up to the reality. The reality is that things are reasonably healthy for the economy. We see no reason to alter our positioning, remaining invested but vigilant.

Fixed Income – A Neutral Stance?

Ten Year Yields Have Fallen Marginally, But We’re in a Hiking Cycle…

Despite the RBI raising rates by 25 bps, the 10 year g-sec has declined marginally. However, in building fixed income portfolios, investors would do well to recognize that while the expectations may be ‘one and done’, the reality is that any number of influences can send interest rates higher, and risks remain to the upside.

OIS Spread suggests One Additional Hike

The spread between India’s one-year and five-year overnight indexed swap rates narrowed as the MPC’s neutral policy stance and balanced commentary eased fears of multiple rate hikes in coming months. The one year OIS rate has edged up recently, and is indicating an additional hike, while the five year rate has fallen as fears of a series of hikes have abated.

Balancing Currency, Inflation & Growth

With the RBI Governor voicing concerns over a currency war, it’s clear monetary policy will need to walk a tightrope. On the one hand, the Rupee needs to be protected; however, liquidity must be provided as well to ensure that lending does not dry up. The rate hike demonstrates that the RBI is serious about inflation targeting and comfortable with growth. Meanwhile, the RBI’s bond purchases, part of its money market operations, have been modest and done little to help bank liquidity. Risks remain that lending rates could rise if liquidity tightens.

Mutual Funds Active at the Short End

Indian mutual funds continue to remain active at the shorter end of yield curve and have reduced duration until there is better clarity on policy rates. Most mutual funds have been active in three-month T-bills. Short-end yields have risen in recent weeks.

INR Reprieve

With hints of a slowdown in U.S. tech company momentum, and rising risks related to trade wars, the Rupee is likely to get a reprieve, aided also by the decline in crude prices. Further, the yield and currency return offered by India is one of the most attractive yields today. While inflation will certainly remain a key risk, the decline in crude, alongside rate hikes and declining disposable income are likely to exert downward pressure on inflation.

Fixed Income Portfolios

Investors with high risk appetite may opt for credit risk funds. According to Sebi’s new norms, at least 65 per cent of the portfolio of a credit risk fund must be invested in AA and lower rated bonds. Only investors comfortable with this kind of exposure should invest in these funds. For this category, go with a fund house that has good research processes in place, and make sure that the portfolio is diversified. Short-term debt funds, corporate bond funds and low duration, accrual strategies remain safe yet attractive options.

Technical Commentary

The Nifty closed at 11361 levels up by 0.73% for the week. After breakout above its previous all-time high of 11172 levels last week index has shown follow through action. Now holding above 11230 levels expect rally to continue towards 11470 and then 11570 levels on the upside. On the downside 11172 level which is the previous all-time high will act as support for the market. In last couple of weeks market breadth has improved which is reflected by rally in BSE Mid and Small Cap indices. BSE Mid Cap is showing signs of breakout from downtrend suggesting broader markets to participate in next leg of rally. In Nifty options, Put writing was seen in strike price 11000 to 114000 indicating supports are shifting higher while unwinding was seen in 11300 to 11500 suggesting opening of higher levels. India VIX at major support level of 12 and any jump from current could dampen the rally.

Technical Commentary

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