• DECEMBER 1, 2004

Mid-caps: On a high!

History was created yet again on the Indian bourses yesterday. We are referring here to the Sensex, which managed to close for the first time ever over the 6,200+ levels. During the process, it also touched a level (6,248) that was just shy of the all-time high of 6,250 attained earlier in the year (January 9, 2004). However, while we have discussed in the past about what we believe from hereon about investing at the current levels, today we once again focus on the mid-cap side of the market, which too has been on fire since the last few months.

Gains in…
  CNX Mid-cap 200 NSE-50
Jan 03-Jan 04 136% 72%
Jan 04-Nov 04 27% 4%
Jan 03-Nov 04 199% 79%

It must be noted that ever since the rally began in 2003, the mid-cap segment has attracted much larger attention on the bourses. The table above confirms this fact with the CNX Mid-cap 200 index gaining nearly 200% against the near 80% gains of the NSE-50 index. While a major credit for this rally can be attributed to the strong FII inflows that have been witnessed over the last couple of years, investor participation at the retail level seems to have also aided the momentum.

While the FII support can be gauged from the near US$ 6.6 bn dollars they put into Indian equities in 2003 and have already invested a similar amount in the first 11 months of the current year, the retail participation can seemingly be gauged from the number of trades that take place on the bourses. It must be noted that while the number of FIIs registered in the last two years has increased from under 490 at the start of 2003 to the current 628, it would not be inappropriate to assume here that since retail investors buy/sell stocks in small quantities, it leads to larger number of trades on the bourses. Just to put things in perspective, the number of trades has shot up substantially from the early 2003 levels of about 1 m trades on the NSE to the current 1.6-1.7 m trades. Even on a yearly average basis, 2004 has seen nearly 30%-35% extra trades compared to 2003.

Considering all of the above and the 'one way up' rally witnessed amongst mid-cap stocks, most of which are devoid of any fundamentals, we conducted a poll on our website with the intention of gauging what retail investors thought about the current mid-cap rally and whether they believed that the run-up has been overdone? The result - while 52% of those who voted believed that the mid-cap rally is overdone, an almost equally strong number (46%) believed otherwise. As far as our stand is concerned, we believe that the mid-cap rally has been much sharper than anticipated and currently factors in much of the growth likely to be witnessed over the next few quarters.

Further, it must be noted that there are various inherent risks associated with investing in mid-caps like lack of information pertaining to the company, concerns related to management quality and integrity and the volatility in earnings owing to the smaller size of the companies. While we are not against investing in mid-caps, we believe that smaller companies have a relatively higher chance of failing, which could either be, among many reasons, due to their lack of experience or limited financial support to ward off competition, thus making their futures rather fragile.

While we do agree that smaller stocks could become potential winners in the medium to long-term, there is a high-risk premium attached to investing in such stocks. And to mitigate the higher risks, the most important point here is that no investment should be considered in any stock that is not well researched. It must be noted that strong fundamentals, viable business model and trust worthy management are amongst the key ingredients that go into making a strong research.

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