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The Big India Revival

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Best Midcap Stocks to Buy

Indian Rayon, Premier Ltd, Gujarat State Fertilizers, Hindustan Motors, Bombay Dyeing, Mukand Ltd and Century Textiles.

Do these names ring a bell?

Maybe they don't. Unless you've been investing in Indian stocks for almost three decades.

Those who have, would recall these were the Sensex's most hallowed businesses back in 1992.

In 2021, we complete 30 years of India's economic liberalisation. The reforms unleashed in the 1991 Budget helped break many regulatory bottlenecks for Indian businesses.

In theory, every well-established listed company then should have been a raging stock in the decades to follow.

The Sensex has become a 12-bagger between 2002 and 2021. A patient long-term investor in Sensex 1992 stocks should have enjoyed similar fortunes.

Unfortunately, not every Sensex 1992 stock went on to create shareholder wealth. Many faded into oblivion.

In fact, only seven of the Sensex 1992 companies remain on the index today.

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Midcaps Today - Sensex Heavyweights Tomorrow

The reason I am referring to Sensex 1992 is because even the best bluechip in the Sensex of 2021 could possibly fade into oblivion in the coming decades.

This is why a shrewd long term investor must pay attention to solid midcaps that have the potential to make it to the benchmark index in a decade or so.

Identify Sensex 2030 Stocks Today

Yes, we can expect many Sensex 2021 stocks to go the way of Premier, Hindustan Motors, and Century Textiles. Indeed, few are likely to feature on the Sensex of, say, 2030.

All the blue chips of today may not be the blue chips of tomorrow.

No doubt, bluechips typically are among the safest investments for the medium term.

But investors willing to hold few stocks for tenure of ten years or more need to look beyond blue chips.

And solid midcaps can be the best solution.

Provided you have filtered your midcaps through some essential criteria.

Key Criteria to Filter Midcaps

Balance Sheet Strength: No matter what size stock you're interested in, it's important to invest in companies with strong balance sheets (essentially with very low debt). Given the unpredictability of business, a strong balance sheet can help companies survive the difficult years.

Moreover, when investing in mid-caps, you are in a way combining the financial strength of a future bluechip with the growth potential of a past small-cap. So it is important to secure the above-average return potential with a solid balance sheet.

Growth Potential: Revenue and earnings growth are the two most important factors in long-term returns. Midcap stocks tend to show higher growth rate as they are more agile than bluechips and more experienced than smallcaps.

Investors interested in mid-cap stocks should consider the quality of revenue growth when investing. Unless the growth comes with better margins and better return ratios, without adding too much debt, excessive growth stocks are best given a miss.

Management Quality: The most important factor one should be mindful of while investing in midcap companies is management quality. Unless the midcap companies have the management bandwidth to sustain the level of transparency, corporate governance, and capital allocation skills expected of a large bluechip stock, investors should be wary.

Moat and Competitive Advantage: Moat and competitive advantage allow companies to constantly innovate and offer new products or new pricing.

Midcaps with a niche presence or a large market share in a niche sector, tend to have higher growth potential and value creation ability over the long term.

Free Cash Flows: Midcap companies that constantly enjoy high margin and positive free cash flows across market cycles tend to get significant valuation rerating over a period of time as they mature into bluechips.

Midcap Valuations - Don't Price in Too Much Growth

There is no doubt that midcap stocks do have bigger growth potential than their larger counterparts.

But first, not all will be able to capitalise on this opportunity. Only the companies with good businesses and a right strategy will be able to grow consistently.

Second, valuing midcaps based on their growth potential over many years can be a huge mistake.

This is because the execution risks could subject the midcap to sharp corrections from time to time.

Midcap companies tend to be more receptive to change especially in terms of technology. With rapid growth, they could eventually acquire the scale necessary to make them big bluechips.

However, the valuations at which the midcap stocks are bought must reflect the challenges ahead of them before they actually go on to become solid bluechips.

How Much Should One Invest in Midcap Stocks?

By virtue of their relatively conspicuous media presence and relative transparency of financial transactions, midcaps can be considered safer than the smallcaps.

However, you cannot take their safety for granted.

There are several midcaps that have eroded shareholder wealth and bit the dust due to poor capital allocation, lack of corporate governance, and management apathy.

Investors should bear in mind that all midcap stocks are NOT wealth creators. Even over the long term.

However, midcap stocks are the safest bets for investors with a very long tenure in mind.

And for any equity portfolio, the allocation to midcap stocks tends to be the least volatile across market cycles.

So, we recommend holding 25 to 30% of one's total equity portfolio in midcap stocks.

Further, we believe that a single midcap stock should ideally not comprise more than 5-6% of the total money allocated towards equities.

Which are the Best Midcap Stocks to Buy Now?

Midcaps can literally have the best of both worlds...quality and potential.

However, buying the best midcap stocks does NOT mean picking a few from the benchmark BSE Midcap Index.

I am certainly not making any stock recommendations here.

But thoroughly screening midcap stocks based on quality of business, growth potential, and valuations can help your arrive at some of the best buys.

Here are links to some insightful Equitymaster articles and videos on midcap stocks