Why are fund managers raising exposure to mid-cap companies?

In the last couple of months, fund managers have taken a bottom-up approach to a number of such mid cap and small cap stocks. Here is a list of stocks that mutual funds bought in March 2020.

Mar 30, 2020 10:03 IST India Infoline News Service

The graph below best captures the relative story of large caps versus mid caps in India in the last one year. Between April 2019 and January 2020, the two indices were almost neutral for the fiscal year. There was no outperformance but there was no underperformance either. The real action was visible from late January till the end of March. The Nifty may have given up nearly 37% but the mid cap index fell more than 62% during the last 2 months.

Data Source: NSE

Mutual funds have been buyers into mid caps even in March 2020

Fund managers have been increasingly concerned about the kurtosis in markets with a handful of stocks virtually dominating market performance. With mid cap valuations a lot more reasonable, it was time to start looking at these stocks. In the last couple of months, fund managers have taken a bottom-up approach to a number of such mid cap and small cap stocks. Here is a list of stocks that mutual funds bought in March 2020.
Stock Which MF bought in Reason for purchase
Sudarshan Chemicals Ltd. Axis Mutual Fund Strong sales and profit growth in the chemicals business. Poised to fill the gap left by China.
La Opala HDFC Mutual Fund Strong and profitable play on the home consumptions segment with largely de-risked business model.
Narayana Hrudayalaya SBI Mutual Fund Sharp increase in ROCE from 9% to 18%. Rising occupancy rates promise better profit yields
Shaily Engineering Plastics IDFC Mutual Fund Niche player in the engineering plastics space and betting on rising demand in the future.
Varroc Engineering Nippon Mutual Fund A low risk bet on the auto ancillary space after a sharp correction in the market price

For the month of January, mutual fund net buying in mid caps and small caps at Rs3,500cr was nearly 5 times the investment in large caps. However, this momentum of investing in mid caps could not be sustained in March due to the sharp correction in the markets. However, mutual funds have shown that they are still open to buying stocks in specific pockets in the mid cap space.

Large caps outperformed mid caps between 2018 and 2020

Between 2014 and 2017, the big returns clearly belonged to the mid caps and the small caps. During these 3 years, the mid caps managed to substantially outperform the large caps. The large cap outperformance started in Feb 2018 when the long term capital gains tax on equities was announced. That was when the rush to book profits in mid caps started. This was followed by the mutual fund reclassification norms announced by SEBI which led to substantial selling in mid caps as large cap funds had to forcibly realign. In addition, SEBI and the exchanges imposed additional special margins (ASM) on a number of mid cap and small stocks to curb volatility. This led to consistent underperformance by mid caps from early 2018 onwards. While there has been interest returning to mid caps from the last quarter of 2019, the party may have been largely spoiled by the COVID-19 pandemic. However, after the sharp correction, the mid caps have once again become attractive in valuation terms.

Crude Oil prices and interest rates

One of the ideal combinations for mid cap stocks to perform is a combination of low oil prices and soft interest rates. Most mid caps are either single or dual product companies. They tend to be vulnerable to cost shifts. Higher crude oil prices tend to impose a huge cost on them. The second factor is interest rates. Mid caps, by default, are required to pay higher yields compared to large caps. Therefore, a soft interest regime is more profit accretive for these mid cap companies. With oil prices falling below $30/bbl in the Brent market and the RBI cutting rates by 75 basis points on 27th March, the situation is conducive for mid caps. In addition, a stable currency generally tends to work in favour of the mid caps as well as monetary loosening. All these are available right now. The sweet spot for mid caps may be back all over again; that is what mutual funds believe.

Data Source: NSE

Mid Cap index at a rolling P/E of 14.70 is the lowest that the mid cap index has been in a very long time. This is what is giving a lot of mutual fund managers the comfort to buy mid cap stocks. One reason interest in mid caps slowed down in March was that buying mid caps is not just about valuation but also about momentum. The ratio of Midcap P/E to Large Cap P/E at 0.85 is a signal that, along with valuation comfort, momentum in mid caps is also back. That could work in favour of mid caps!

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