early to fall? No, that does not seem to be the case with the Indian mid-caps (defined by NSE as scrips with average six months market capitalisation ranging between Rs 750 m and Rs 7,500 m), which continue to defy gravity despite little fundamental backing. While their larger peers have shown some moderation in valuations, the 'positive sentiment' on mid-caps shows no signs of abating.
Cliche as it may sound, but mid-caps have time and again proven to be the worst hit at the slightest sign of a rally sizzling out. While the larger entities have better resistance to sectoral cyclicalities, economic downturns and competitive pressures, the smaller entities often succumb to the same. Concerns on factors like management quality, earnings volatility and lack of operational transparency get further highlighted in unfavorable times. While their larger counterparts get active media coverage, mid-caps garner little interest and the lack of information on them puts investors at a disadvantage. Also, by not disclosing information proactively, some companies actually encourage the 'rumour mill' to work overtime.
Warren Buffet, in one of his letters to the shareholders of Berkshire Hathaway wrote, "Management cannot determine market prices, although it can, by its disclosures and policies, encourage rational behavior by market participants." Managements of smaller companies, however, tend to shy away from such 'disclosures', thus keeping the investors in the dark.
All said and done, it calls for some wisdom on the part of the investor to acknowledge the fact that an incessant upswing in the prices of mid-cap stocks, which are devoid of any fundamental backing, is not what they should get lured by. Especially at times when even the best of the mid-cap 'stories' seem fully priced, the time is ripe for one to contemplate on the longevity of their rally and mull on the correction rationales. Here we suggest a few rationales for select sectors.
The correction rationale...
Auto: Lower capacity utilisation, poor dealership network and pricing pressures are concerns that the smaller players in the auto industry are finding difficult to circumvent. High international crude oil prices, which would inevitably be reflected in domestic oil prices, and competitive pressures (by way of cannibalisation of market share) from the larger entities, have only added to their woes.
Banking: With traits similar to that of a commodity business, banks too are now not spared from pricing (read margin) pressures and rising competition. Scalability of asset size (through adequate capital and reach) and sustainability of asset quality remains strengths restricted to the larger and well-established entities. Also, with the augment of Basel norms and threat of competition from foreign entities on the anvil, independent existence is but a challenge for smaller banks.
Commodity: With larger players leaving behind the smaller entities in terms of backward integration leading to lower costing and specialisation in high yielding 'value added' products, smaller entities remain largely exposed to pressure on margins. Also, with the supply side not decelerating, pressures on the 'pricing' front remains to be tackled. Thus, while the larger entities may go relatively unscathed with say a 20% correction in commodity prices hereon, the same may create a significant dent in the bottomline of the smaller players.
FMCG: While the FMCG sector offers huge growth potential to smaller players due to poor per capita consumption in the country, companies in this sector, continue to face margin pressure. Also, competition has intensified in this space with smaller players like Nirma and CavinCare giving the larger players a run for their money. Further, if the price war (like the one last year when P&G announced price cuts by as much as 50% on its detergent folio, forcing all players in the segment to follow suit) were to recur, smaller players will have their margins completely squeezed, which might force them to choose the exit route.
Pharma: With the advent of the product patent law, Indian pharma companies are looking at generating revenues from the generics portfolio in the regulated markets, contract manufacturing, licensing deals and acquisitions. In case of generics, considering the intense competition and price erosion, the key will be a strong marketing and distribution network and introduction of new products. Similarly, contract manufacturing will entail securing relationships with generic companies and getting the facilities approved by the USFDA. Therefore, while growth sustainability will not be an issue for companies having a strong R&D focus and distribution network, the mid cap pharma companies will have to fight a tough war for survival.
Thus, we reckon that...
Valuations are ripe across sectors and some part of India Inc. is already coming to terms with the fact that the 'supernormal' results posted by them over the past few quarters may not be sustainable going forward. While the larger entities have had the modesty to acknowledge the same, lot remains unsaid about the second rung entities. It is but pertinent for investors to beware of 'supernormal' stories and adopt a bottom-up approach to suit their risk appetite.
The same is best explained in another advice given by Buffet in his letter to shareholders "If a CEO is enthused about a particularly foolish acquisition, both his internal staff and his outside advisers will come up with whatever projections are needed to justify his stance. Only in fairy tales are emperors told that they are naked."