Ten things to monitor if you invest in mid-cap stocks

2 May 2022 , 03:00 PM

As large cap stocks continue to be volatile, the retail investors are increasingly veering towards mid-cap and small cap stocks in search of alpha. Small investors have always had a special attraction for small and mid-cap stocks as they theoretically offer better chances of capital appreciation and wealth creation. However, there are some basic rules you need to understand about investing in mid and small cap stocks.

Most mid-cap stocks are not tracked too closely and you do not have an army of analysts studying the stock and the company from every possible angle. That means; the higher growth potential in mid-cap stocks comes with higher risks. That is why, investors must ensure that before investing in these mid-cap stocks, they do their homework. It would be too much to expect small investors to apply the same rigor in analysis as a fund manager. However, apart from understanding why you are buying the stock, there are some basic tests you must apply to mid-cap stocks.

The legendary Peter Lynch rightly said that behind every stock there is a company and behind every company there is a business. Try to understand that business. Like it or not, you must not invest in a stock without understanding its business and its prospects. But there is a lot more to investing in mid-caps than just understanding the business.

Test 1: is the mid-cap stock liquid enough?

This is one of the most important tests to apply. We call a stock liquid if you can buy and sell the stock in a reasonably large quantity without impacting the price. For instance, if the stock falls 5% by selling 5,000 shares, then something is wrong with the stock. The most important consideration for the investor is that they can exit the stock without too much price damage. One rule of thumb is for investors to be cautious about mid-cap stocks where a bunch of broker or proprietary traders have purchased huge quantities. These shares are prone to a rapid selloff and major price damage. Talk to your broker for such information.

Test 2: Past financial performance is not final, but it is decisive

It is said that you can fake financial performance for 1 or 2 years but faking over 5 years is too difficult. When you look at the financials like profits and margins, look for consistency. A consistent track record of good performance over the last 4-5 years is a valuable indicator of the stability of the company. It shows that the company has handled vagaries of the environment well and is adaptable. However, if you see red flags like revenue inconsistencies, too much other income or exceptional gains/losses, it is time to be cautious.

Test 3: Is the mid-cap stock vulnerable to macro changes?
Take stock of the pressure points of the mid-cap company you are investing in. Many mid-cap stocks tend to be more vulnerable than large caps to shifts in macro factors like interest rates, oil prices, exchange rates etc. Most of the mid-cap companies rely on a handful of clients so be wary if there is too much dependence on a handful of companies or sectors.

Test 4: Has the mid-cap stock given absolute returns?
This is an important point. Unlike large caps, you don’t buy mid-caps to beat the index, but you look for higher absolute returns that can compensate for the  higher risk levels. Don’t focus too much on 1-year returns, but over a 5 year period, the stock returns should have been solid in absolute terms. That logically means, you avoid mid-caps without a track record of at least 5-7 years in the stock market. You need some history to fall back upon.

Test 5: When it comes to mid-caps, it is the context that really matters
Your mid-cap decision should always be contextual. For instance, keep a thumb rule that mid-caps must not exceed 30-40% of your equity portfolio. This would again vary depending on your risk tolerance levels. Accordingly, decided your total exposure to mid-cap stocks and stick to it. Like a typical asset allocator, if you exceed the limit, book profits and ensure that your mid-cap exposure does not deviate too far from the original cap.

Test 6: Management quality is more critical for mid-caps
A good quality management, a viable succession plan and sound corporate governance standards are value accretive for any company. However, this is a lot more applicable to mid-caps. Before you invest in mid-caps, you must ensure that the companies you invest in have robust internal mechanisms and show corporate accountability. A strong and stable management team is a barometer of a well-oiled corporate machinery.

Test 7: Risk lowering is more important than risk enhancement
Let us apply a simple test. How do you choose between 2 mid-cap stocks. The answer is simple; look at risk. Focus on a stock that either manages risk better or the stock that helps you reduce your risk better. The golden rule in mid-cap stocks is that if you can manage the risk, then returns will automatically follow. Most of the mid-caps are in high growth sectors, so growth will follow as a logical corollary. The key lies in handling risk properly.

Test 8: Stocks with high promoter pledges are anathema
We have seen these instances in so many cases where heavy pledging forced a change in the ownership. It happened in Zee Entertainment, Dish TV, Eveready Industries; and the list can go on. The thumb rule for retail investors in mid-cap stocks is that if the promoters have pledged more than 50% of their holding with banks, it is a high risk scenario. Such stocks are best avoided as they are vulnerable to shocks.

Test 9: Be wary of negative regulatory and media attention
We have seen mid-cap companies facing the flak of regulators like SEBI, RBI, IRDA etc. You must be cautious about regulatory red flags and too much of negative media attention. Keep a tab on social media handles and discussion forums to check for any negative news flows on the mid-cap stock.

Test 10: Look for bear market champions
It is said that in bull markets everybody looks smart, however it is only in bearish markets and lacklustre markets that the men are separated from the boys. It is during such bad times that the mettle of the company is truly tested. Mid-cap champions in bear markets will automatically outperform in the long run.