The BSE Midcap index has risen 126% in the past 12 months. During the same time, its peer comprising smaller cap stocks, the BSE Smallcap index rose 157%. With this each of them managed to trump the performance of the heavyweight index, the BSE Sensex that rose 78% since January 2009.
The growth in sales and profits of constituents of the mid and small cap indices during this period also bore similarity to a rising phoenix. Higher sales, lower cost of input as well as leverage coupled with better demand scenario made the going smoother for these lesser known entities. Raising funds for expansion became easy and cheap. There was little more that these entities could ask for. Their high double digit growth in earnings was rewarded with higher valuations. The economic slump in the developed nations seemed to be a boon in disguise. It literally was a 'honeymoon' period for the smaller companies where even petite changes in sales and cost show a magnified impact on growth and profitability.
But what comes hereon, may bring them a new set of worries. High inflation could crimp margins and tax hikes may dent demand for goods and services. The RBI's hint at monetary tightening does not go too well with their freshly leveraged books. Besides renewed demand from infrastructure and consumption sectors is set to take a backseat. The economic recovery came in amid sharp tax cuts and stimulus measures. Neither of these seem sustainable as fiscal worries loom large.
Raw material prices are on the rise after a benign 2009. As commodities get dearer, the companies will have to use their pricing power to sustain margins. In most cases the odds are heavily stacked against them. With rising interest rates and record-high food prices, consumers are prone to down trading (buying cheaper substitutes). Further, with economic recovery gaining stability, firms may once again be under pressure to hike wages, hammering away at their profit margins.
Ones that have made ambitious plans to raise equity may have more than one reason to reconsider their options. For one, the larger companies are themselves lining up in the primary market in a bid to solicit funds. They are infact competing with PSU divestments as well as the government's own debt borrowing plans. Secondly, with investors being spoilt for choice, competing in the capital market may also lead to additional equity dilution. The diluted returns in turn may hurt their valuations as well.
The surge in export demand from the beaten down developed economies may also be short-lived. For governments in those economies are getting more answerable for their fiscal opulence. The stimuli funded recovery in the developed economies may thus see an early exit. And then, exports from emerging markets could remain vulnerable to the growth and employment in the developed world. Nothing would be more impacted by such a change in global trade than the fortunes of some of the export dependant small companies in India.
Should you stay invested in them?
The question that arises here is whether you should continue to stay invested in the mid and small cap companies? We ask: why not? If you have invested in the company after being convinced about the sustainability of its business model across economic cycles and the correctness of its valuations. Companies whether they belong to the large, mid or small cap space have business models that could be vulnerable to economic cycles. However, what is important is to ensure that the business has the moat and the management skill to tide through any crisis. Firms that build up efficiencies in their processes can continue with cost cuts to sustain margins and investor returns. Further, as the legendry Buffett says, if you have purchased the business at the correct price, the time to sell is never!
So be it lower EPS, inflation, interest rate, lower GDP or stimulus withdrawal, neither should get you unduly worried about your investments in mid and small caps. Unless you have put in your money at the wrong time or without adequate homework. Even Buffett envies retail investors who can buy small stakes in undervalued lesser-known companies.