Midcaps: Potential to perform...

The BSE-Sensex having gained 42% point to point so far in 2006 leaves very little room for investors to complain about their returns garnered from the index heavyweights. But where do we go from here on? Should investors continue to rely on the wishful thinking that the economic buoyancy would continue to propel the market capitalisation of large caps to higher trajectories? Or does this deserve a re-thinking?

Rs 100 each invested in Sensex and BSE Midcap index at the beginning of the year would have yielded a return of Rs 42 and Rs 29 respectively till date. The fact that the Sensex has appreciably outperformed its midcap peer leaves us to wonder about the upsides from here on. A valuation of 21 times trailing 12-months earnings suggests that the Sensex has reasonably factored in some of the future gains. As against this, the BSE Midcap index, albeit comprising of stocks with high beta (risk association), does not seem to have been suitably rewarded for the high return ratios and incremental growth potential.

India Inc. - Witnessing the 'SME uprising'
India's liberalisation program has so far been very successful in developing a large-sized private corporate sector. However, companies form the small and medium-scale (SME) sector have grossly under performed their larger counterparts. A combination of improving domestic demand due to higher employment and per capita income is likely to drive a significant change in the SME sector as the larger corporates fail to cater to the entire demand.

Neglected so far...
The two most important factors that caused this conspicuous gap in performance of the large companies versus SMEs is the availability of infrastructure and access to capital. While their larger counterparts managed to side step this hurdle by investing in captive electricity, port and transport facilities, the SMEs suffered from the lack of resources. Not surprisingly, over the last few years, the share of SME in overall exports has been stagnant. In addition, the share of bank credit to this segment failed to garner a substantial pie until the last 2 years due to lack of credit rating.

Potential triggers to value unlocking...
Retail revolution: Globally, organised retail players tend to source about 30% to 50% of their supplies from small and medium scale industries. A large number of their supplies are in form of private label products, and SMEs are best placed to meet this demand. We believe that large Indian retail chains will nurture the SME sector to cater to domestic demand. However, the challenge is to get the SME sector to build capabilities to meet the cost and quality requirements of the discerning overseas consumers. Also, it needs to be comprehended that growth will not be without competition. Unlike India, China developed a globally competitive SME sector before it developed a large-scale network of organised retail chain stores. Moreover, China has already built in economies of scale advantages in certain goods where it will be difficult for Indian players to compete in the near term.

Nonetheless, higher domestic demand and subsequent improvement in the competitiveness of SMEs in complying with the requirements of the domestic and overseas customers should eventually allow them to increase their market share in global exports.

Pace of infrastructure development: Currently, except for telecom, the cost of most utility and infrastructure services in India is estimated to be 50% to 100% higher than that in China. For instance, the average electricity cost for manufacturing units in India is roughly double that in China. Similarly, the average cost of freight payments as a percentage of imports is about 10% in India, compared to around 5% in developed countries and an overall global average of 6%.

Having said that, the lack of basic infrastructure facilities and low (as compared to what is required) government spending on infrastructure is impeding efficiency of production for the medium scale enterprises. China is estimated to be spending seven times as much as India on infrastructure (excluding real estate) in absolute terms. In 2003, the total capital spending on electricity, roads, airports, ports and telecom was US$ 150 bn in China (10.6% of GDP) compared to US$ 21 bn in India (3.5% of GDP). However, given the set of reforms being introduced by the government for different sectors to accelerate infrastructure spending (including support to institutions like IDFC), the country's infrastructure investment is expected to touch US$ 47 bn (4.7% of GDP) by FY09.

Although this is still significantly lower than the required levels, it should provide some support to the SMEs. In addition, the government's liberal policy for SEZs (special economic zones) is seen as a step towards the emergence of large multi-product SEZs, to bridge the gap for lack of quality nationwide infrastructure availability, thus facilitating the growth of SMEs operating in their vicinity.

Conclusion
While the BSE Midcap index is not a very apt representation of the SME segment per se given the limited representation of companies in the index, what needs to be kept in mind is the fact that the representation is only set to multiply as companies mature to the benchmark performance levels. Also, while most large cap stocks - given the fact that they are widely tracked - tend to most often factor in considerable upsides, the mid caps offer ample opportunities for value buyers. It is for investors to reckon this opportunity and carefully select / research the 'Infosys in the making' that deserves a place in their portfolio.