Equity markets follow cycles of troughs and peaks where the wider markets witness intermittent periods of gains or losses. However, even within these phases, we see certain stocks outperforming other stocks. In the current market rally, we have seen large-cap stocks outperforming mid-cap stocks. However, the general belief is that mid-caps stocks have the potential to generate superior returns compared to large-cap stocks. Over the last two years, midcaps have fallen more than 25 per cent while Nifty rose 13 per cent. The question that most investors are now faced with is whether the current period is a good time to start increasing exposure to mid-cap mutual funds.
Midcap mutual funds are equity mutual fund schemes that are mandated to invest a minimum of 65 per cent of their assets in midcap stocks. According to Sebi classifications, the top 100 stocks by market capitalization are large cap stocks, the next 150 stocks are midcap and the remaining ones are small cap stocks. Large cap stocks are stocks of companies that are market leaders in their respective industry/sectors. These companies are well past their aggressive growth years and are characterised by slow and steady growth. Small cap companies, on the other hand, are companies in the nascent stages of growth. They are nimble and emerging and offer the potential for high returns. However, since these companies are very small and emerging, the uncertainty associated with their future growth is also very high. Mid-caps occupy a space between these two. While they are still small, they have already established some leadership in a small industry or occupy niches in established sectors. As a result, mid-caps have a higher growth potential than large-caps but a lower downside than small-caps.
The last 2 years have seen mid 7 small-cap stocks witness a sharp correction. The Nifty Midcap 100 TRI fell 19% in 2018 and has fallen 14% on a YTD (as on 30th September 2019) basis. Another important point to consider is the valuation gap between mid-caps and large-caps. Usually, mid-caps trade at a discount to large-caps in terms of valuations (P/E ratio) because large-caps are considered to be less volatile (risky) than mid-caps. The correction witnessed by mid-caps in the past year has seen the mid-cap P/E correct from 25.6 times earnings to 15.9 times (as on 30th September 2019). The valuation gap between the mid-caps and the large-caps has only widened and seems ripe for mean reversion. Having said that, the bleak macro-economic conditions currently prevailing in the country are likely to impeded recovery in the mid-cap space.
The bottom line is that long-term investors can now consider gaining exposure to this segment by making a small lumpsum investment or starting a SIP in a mid-cap mutual fund.