How to be in green in broad red market ???

Mid-caps have so far had a great run in the rally from the March 2009  lows. While the CNX Nifty only doubled in value, the CNX Midcap delivered a much stronger 170 per cent return in the same period.

ARE the mid-cap stocks are overheated? Well, not really.

Though the initial leg of the 2009 rally saw mid-cap stocks take the lead over their large-cap peers, these stocks haven't enjoyed as much of an expansion in PE multiples as their large-cap counterparts.

While CNX Nifty saw its PE multiple expand from 12 times to 21 times between March 2009 and end-May, that of CNX Midcap rose just from 8 to16 times. The valuation gap makes a reasonable case for investing in mid-cap stocks.

Though it has narrowed since, what with the PE multiple of the Midcap index edging up to over 18 times now, the gap still is nowhere near the earlier instances of ‘overbought' levels. For one, unlike market rallies in the past when the valuation gap between mid-cap and large-cap stocks had narrowed down considerably, the gap this time around does seem to leave reasonable room for appreciation.
For instance, between October 2007 and January 2008 (before markets crashed), while the PE multiple of CNX Nifty had moved up from over 26 to 28 times, that of CNX Midcap had expanded more from 20 times to over 26, narrowing down the valuation gap between the two indices considerably and in no time. Little surprise that it was soon followed by a crash in equities. Even in May 2006, just before the market suffered a significant fall, the valuation gap between the indices had thinned down noticeably. The mid-cap index valuations had even briefly surpassed that of Nifty-50 then.

Even if we look at the five-year historical average, mid-caps do not seem to be overheated. The five-year average gap between Nifty and CNX Midcap has been at about 8-10 per cent and the current valuation gap is perched in the 14-18 per cent ‘safe-zone'.

What about earnings?

Mid-cap stocks have reported improved financial performance, though it largely was only in keeping with the improved business environment and liquidity conditions. In the just-ended September 2010 quarter, the list
of companies comprising the CNX Midcap index reported a 5.3 per cent growth in sales over the corresponding quarter last year.

Profits however dipped by over 10 per cent, driven down by a drop in operating margins and interest cover
Does that mean mid-caps still have a long road to recovery? While to some extent it does mean that, much of the current mid-cap valuations are primed for potential future growth. This may also explain why the CNX Midcap Index is offering higher earnings growth for FY11 and FY12
(based on consensus forecasts) compared to the narrow indices.

That the companies have grown their sales on a sequential basis too suggests that the revival in demand is perhaps beginning to trickle down to mid-cap companies too. On a sequential basis, these companies reported a 3.3 per cent growth in sales. However for the growth to reflect below the line, access to liquidity would be crucial, as mid- cap companies still haven't seen any marked improvement in interest cover

Improving cash-flows as demand perks up and an easing capital-raising environment for mid-cap companies, therefore, may hold the key to earnings growth. While an increasing interest rate scenario could spell more challenges for mid-cap companies, pegging up their cost of capital, it still may not be as difficult to raise funds as it was during the credit crunch of 2008. Besides, with demand drivers slowly falling into place, the cost of credit may not bear that high an influence on business fundamentals, at least as long as the overall economy continues to grow.

But which sectors have enjoyed a higher re-rating and which lower in the rally so far? Companies from engineering, infrastructure, capital goods and shipping have enjoyed a significant re-rating over the year.

Hotel stocks and select pharmaceutical companies too have seen their PEs gallop over the year.

The re-rating seems to have also been earnings driven, to certain extent, what with the divergent earnings performance. While companies in sectors such as chemicals, consumer goods and sugar did not quite impress with their performance, those in pharmaceuticals, engineering, infrastructure, and real estate scored high.

How to go about it?

While mid-caps as a category do hold significant investment potential, how much of it can be extracted depends a lot on sector and stock choices as well as the tenure of investment. Additionally, look out
for companies with healthy operational cash flows and moderate leverage as they are better placed to ride a rising interest rate regime.

While lack of credible investment information on some stocks in the mid-cap space can be a big hindrance, you can take cues from the investment moves made by institutional investors.

However, remember, such stocks also are more prone to falls during periods of market correction. Interestingly, the FIIs have already increased focus on mid-caps; their stake as a percentage of the total
equity base of CNX Midcap index stocks now stands higher at 15.9 per cent (Septmber 2010 quarter) from 13.9 per cent seen in the year ago quarter.

It was at about 14.7 per cent in December 2009. Domestic institutional investors, comprising mutual funds and insurance companies, on the other hand, have slightly decreased their mid-cap exposure to 10.1 per cent from the 10.5 per cent level of a year ago.

Book profits regularly
Investing in mid-caps can become a bit too bumpy a ride for many investors, as their stock prices tend to be more volatile than their large-cap peers.

As the impact cost of transacting in mid-caps is higher (than that of large-caps) these stocks are more prone to downside risks during market corrections. Investors may, therefore, do well to take profits regularly.
A good indicator can be the valuation gap between the Midcap index and the Nifty. Thinning of the gap below the average should perhaps be reason enough to sweep some profits off the table.