Are Midcap stocks currently the best bets on India's economic revival? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Are Midcap stocks currently the best bets on India's economic revival? 

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In this issue:
» Major reforms lined up for capital markets
» New Companies Act making independent directors jittery!
» Infosys's management exits: Should investors be worried?
» Should investors have gold in their portfolio in current times?
» ...and more!

00:00  Chart of the day
The corporate earnings season is in full swing. For those of us who listen to company managements after the results, there is one common statement that we are hearing all across - earnings growth has bottomed out. The management of each and every company is painting a brighter picture for investors, based on economic revival with Mr. Modi's Government taking charge at the centre.

Since most investors assume bluechips to be overvalued, it is the midcap stocks that are garnering the maximum interest. In fact the stocks of some of these smaller companies are fetching valuations not seen for long. As one can see from the chart, the markets have already started pricing in this recovery. In the year till date, the BSE-Midcap Index has gain by 25% versus Sensex's gain of 15%.

Good time to invest in Midcap stocks?

Nevertheless, in terms of valuations, the midcap index is currently trading at trailing twelve months price to earnings multiple (P/E) of 11 times and at a price to book value of 0.99 times. This seems to be at a significant discount to Sensex that is trading with P/E ratio of 17.7 times and a P/BV ratio of 2.8 times. In absolute terms as well, the midcap index is trading 17% lower than its highs of 2008. High risk perception, economic slowdown and downgrade in the earnings over last few years had penalized the midcap stocks. However, with hopes of the new government offering better scope for growth, investors are betting big on the re-rating potential of midcap stocks.

What worries us is that an over exposure to midcap stocks, solely in the hope of revision in valuation multiples can be disastrous. Midcaps from the infrastructure, capital goods, metals and realty sectors have seen the maximum run up in recent times. However, even with reforms and turnaround in the economy, fundamentals of stocks in these sectors will not improve immediately but with a considerable lag. And as the market runs out of patience, the valuations could once again get realistic.

It is only companies with efficient management and strong balance sheets that will be able to withstand competition and ride along with the economic growth wave in the long term across the cycles and will lead to real wealth creation for investors. Hence, we would recommend investors to stick to bottom-up approach and invest in companies with strong competitive advantage, efficient management and sustainable business model that can survive for a long time to come. While certain midcap stocks may be ripe for re-rating, it would be best to implement the lessons from the past and act accordingly. A good way to differentiate winners from losers in the mid-cap segment will be how these companies have fared in the tough times in the past.

Further, in order to minimize risks associated with equity investing, investors must stick to the ideal asset allocation. With a disciplined approach, it is quite likely that investors will witness such quality midcap companies wearing the large cap crown in the long term.

Should investors focus only on midcap stocks to create wealth from India's economic revival? Let us know in the Equitymaster Club or share your comments below.

Editor's note: The research team has been meeting some very interesting companies in the midcap space! We will write more on them in the future editions of The 5 Minute Wrapup. Do stay tuned!

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Given the mandate to push through at least few reforms in first 100 days, the Finance Ministry is eyeing the capital markets. Major reforms in both equity and debt markets are expected to be implemented in the next three months. This may not just include liberalization of borrowings norms but also better fiscal sops. The capital controls imposed by the Reserve Bank of India last year are expected to be rolled back. Budget measures may include abolishing short-term capital gains tax and levy of higher securities transaction tax. The previous government's attempts to add some depth to the bond market were to no avail. Further the issuances of Depository Receipts have almost gone to nil in the past few years. These too may see some revival. However what will particularly be of interest to us is to what extent reforms are brought in to encourage retail investor participation. If the Finance Ministry and the SEBI work together to ease investor concerns and facilitate long term investments, the Indian stock markets could see strong domestic inflows as well!

The recent developments in the direction of better Corporate Governance have come along with fresh challenges. The new provisions in the new Companies Act and the new Code of Corporate Governance have made some independent directors quite jittery. The key roles of independent directors include playing an advisory role, preventing frauds as well as protecting interests of all stakeholders; including minority shareholders. Their expertise and guidance are required to help companies grow.

The new Companies Act is likely to make independent directors accountable even for events which might not be under their control. And as noted by the author of an article published in the Business Standard, this clause could possibly lead to an exodus of good independent directors. Well... this is a tricky situation. Nevertheless, we cannot help but think that such stringent measures would be required to set the processes right for doing clean business - or shall we say improvement in the way the organisations are managed. Investors could in fact gauge the board composition and in the process, use this clause to their advantage.

The big news from the software sector recently has been the ongoing saga at Infosys. India's second largest IT firm has been trying to find a replacement for CEO S.D. Shibulal since the last two months. For this purpose, the company's board of directors has put a clear process in place. This has not gone down well with those who considered themselves to be frontrunners for the job. Yesterday, on May 29 2014, the stock was down sharply as co-president, B.G. Srinivas, put down his papers.

Infosys has seen several staff exits, across all levels, ever since N.R Narayana Murthy returned to the company last June. His efforts to revive the company financially and to put in place a clear succession plan have rubbed several top executives the wrong way. While this issue will certainly dampen the prospects of the stock in the short term, there can be little doubt that the company's core business is slowly recovering. Investors would be well advised to focus on the company's improving profitability. The company will most probably find a new CEO in the next two weeks. However, the long term prospects of the stock of Infosys will be driven only by the company's fundamentals. In our opinion, on this front, the last three quarterly results have shown that things are moving in the right direction.

While stock markets are witnessing record high, gold is witnessing a meltdown. The yellow metal had seen a tremendous rally in prices till the 2011 when it peaked at around US$ 1,900 an ounce. But since then interest for the metal waned as prices fell by as much as 35% of its value; according to an article in Market Watch. What really started the fall in prices is the US Fed announcing the trimming of its bond purchase program. It was assumed that the US economy is on the mend and hence no more QE was required. This sparked off a rally in stocks and a softening in gold prices.

But as we have highlighted in many of our editions of the 5 Minute Wrapup, we believe that the case for gold still remains strong as ever. We view the QE taper with a pinch of salt because should the US economy start faltering again, the Fed could once again begin bond buying. Not just that, the incidence of geopolitical tensions has also increased in recent times. All of this means that investors will always look for a safe haven and gold in this regard fits the bill perfectly. Thus, the precious metal should certainly account for some portion of an investor's portfolio.

In the meanwhile, the Indian stock markets pared gains but continued to trade in the green. At the time of writing, the benchmark BSE-Sensex was up by 22 points (+0.1%). Most of the sectoral indices were trading strong led by stocks in the realty and oil and gas space. Banking and consumer durables stocks were trading weak today. Majority of the Asian Indices were trading in the red with Taiwan and Japan being among the major losers. European markets also have opened the day on a negative note.

04:50  Today's investing mantra
"Behind every stock is a company. Find out what it's doing. " - Peter Lynch
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