As good as it gets

Mid-cap stocks are likely to continue their winning streak but the risk-reward in some sectors are no longer favourable

In CY17, small triumphed over big. While, only one stock doubled in Nifty 50, as many as 12 stocks doubled in Nifty Free Float Midcap 100 index. The one stock that doubled in Nifty 50 was that of Bajaj Finance, whose market cap doubled to Rs.101,277 crore. Of the 12 stocks that doubled in the Nifty Free Float Midcap 100 index, Indiabulls Real Estate, Vakrangee and Jindal Steel & Power were the biggest gainers. Over the past one year, while Nifty 50 gained 29%, the Nifty Free Float Midcap 100 index outperformed it by a mile by gaining 47%. 

What’s pertinent to note that depth of outperformance is much more wider in the mid-cap space, much beyond the benchmark 100 stocks. Outlook Business ran a filter of 370 mid-cap stocks with a market cap in the range of Rs.3,000 crore to Rs.26,000 crore and the results were: 72 stocks have more than doubled, while 91 stocks just about doubled. On a sectoral basis, four sectors saw the maximum outperformance. 17 stocks in the financial services sector have doubled or more than doubled; 10 stocks in the chemicals (agro chemicals and fertiliser) sector have doubled or nearly doubled, while seven stocks in the realty and six stocks in the auto ancillaries space have nearly doubled. According to Sanjay Mookim, India equity strategist, Bank of America Merrill Lynch, the falling cost of capital, large surge of domestic liquidity, coupled with improved earnings in these sectors has resulted in re-rating of these sectors. “Auto ancillaries, NBFCs and chemicals [largely agrochem and fertilisers] have delivered on the growth front and will continue to do so, going forward. While retail credit has driven growth for NBFCs, a good monsoon has fuelled demand for agrochemicals and fertilisers.”

NBFCS: Gaining ground?
Even as the phantom of bad loans continues to haunt public and private sector banks, NBFCs occupied the centre stage in CY17. Increased rural demand owing to higher minimum support price, greater thrust of the government on infrastructure development (10% increase in the FY18 budget) and affordable housing have propelled demand for rural credit. Wider diversification in product offerings by NBFCs has also piqued the interest of investors in the sector. As many as 19 NBFCs outperformed Nifty 50. Housing finance companies (HFCs) and stock broking firms were among the best stocks with the top performers turning out to Indiabulls Ventures (1,195%), Edelweiss Financial services (204%) and Centrum Capital (160%). 

While NBFCs have benefitted from tailwinds of lower interest rates for the past 2-3 years, going ahead the picture could change. Pankaj Tibrewal, fund manager, Kotak Mutual Fund, is sceptical of HFCs as interest rates harden. “NBFCs don’t have huge deposits and are more wholesale funded, so whenever liquidity gets a little tighter it impacts their margins,” points out Tibrewal. Concurring with Tibrewal, Gaurav Mehta, fund manager (PMS) at Ambit Investment Advisors, adds that the increased focus of private sector banks on housing finance and PSU bank recapitalisation could result in more competition for HFCs. Unlike banks, NBFCs do not have access to low-cost CASA deposits. With increased competition for the same pie, HFCs, in order to support their growth, could look at lending to the sub-prime category, i.e. financially weak borrowers.

Besides, Mehta believes there is an underlying structural problem in the NBFC space, in the wake of implementation of GST and the government’s thrust on digitalisation. “With the increasing formalisation of the economy, as more and more data become available to lenders, it will weaken the case for NBFCs as thus far they have operated in a system where transparency of data was missing. But as data availability improves banks will have the upper hand, thanks to their scale.”

However, Mehta is bullish on the vehicle financing companies, especially the ones that finance commercial vehicles as some of these companies have created a niche in terms of the profile of their borrowers. “Banks might not find it too lucrative to pursue small ticket, light commercial vehicle financing.” 

Still worth a ride
The auto and auto ancillary space have been performing as well over the past one year. As many as 19 firms from the auto and auto ancillary space (including one tractor-manufacturing firm) have outperformed Nifty 50. The stellar performance came on the back of robust demand for automobiles in CY17, thanks to a strong rural appetite owing to a normal monsoon, and a surge in replacement demand. Both passenger cars and commercial vehicles segments have been beneficiaries. The best performers in the segment that more than doubled were Minda Industries (327%), Escorts (165%) and Endurance Technologies (136%). Maruti Suzuki, was on a roll this year, with its stock price recording a surge of 83%.

Vinay Khattar, head of research, Edelweiss Securities, expects both auto and auto ancillary sectors to sustain the momentum in the current year as well. “India is a 2.75 million car market today, while China is upward of 20 million. Our demographic profile is similar to theirs, so it’s just a matter of time before our market becomes significantly larger than today, as the Chinese markets have become in the last decade. In the case of auto ancillary companies, exports have been a big driver. It’s not only the bigger players such as Bharat Forge, Motherson Sumi, even smaller companies such as GNA Axles are focusing on overseas markets.” The brokerage house has a buy recommendation on number of auto and auto ancillary stocks. Tibrewal, too, is bullish on the auto and auto ancillary space across. “The auto ancillary sector,” according to him, “is consolidating very well, with three to four major players emerging in each segment. The latest wave of electric vehicles also does not seem to be a formidable threat to the internal combustion engine in the near future.” In the Kotak Midcap fund, managed by Tibrewal, automotive sector has an 8.55% weight, comprising of VST Tillers Tractors, Motherson Sumi Systems, MRF and Amara Raja Batteries. 

However, Mehta believes growth in the auto ancillary sector is more cyclical and not structural and, hence, feels current valuations are no longer attractive. “Passenger vehicles and two-wheelers have had a good run over the past couple of years, partly helped by the increase in financing. So, the sector has been re-rated to cyclical highs. While the demand cycle continues to be in their favour, the best of the benign raw material price cycle is over, with rising rubber and crude oil prices,” explains Mehta. The only positive though is that improved cash flow has fortified the sector’s balance sheet. 

Chemicals: The right formula
In case of chemicals, 20 firms outperformed Nifty 50. The top performers were Philips Carbon Black (339%), Gujarat Narmada Valley Fertilizers & Chemicals (131%), Gujarat Alkalies & Chemicals Ltd (116%). A favourable commodity cycle, greater thrust on domestic production, increased rural demand and the closure of chemical firms in China have proved to be a potent combination. The sector has also witnessed major consolidation with eight mergers & acquisitions. While independent market expert Ambareesh Baliga perceives the re-rating of the sector is a result of cyclical factors, with the best seemingly priced in, and currently unfavourable risk-reward, Mehta believes the story is essentially a structural one. Apart from the fact that India has always been competitive in knowledge-oriented industries such as specialty chemicals, the relatively strict adherence to IP laws in India have given foreign innovators comfort in working with Indian companies. Besides, the headwinds faced by Chinese chemical firms over the past few quarters have opened up the market of plain vanilla molecules for Indian companies. “Increasingly, we will see more shutdowns in China, which will only help the case for Indian chemical companies, especially specialty chemicals,” says Mehta.

Tibrewal, on the other hand, has made demarcation in terms of the nature of the firms which are expected to perform going forward. Most firms which have run-up recently are essentially commodity-related chemicals (such as caustic soda) and are cyclical in nature, the niche chemical players (benzene and fluorine-based firms) are witnessing a structural story playing out. “These firms have a moat which nobody can copy easily, and a lot of their user industries are major global agrochemicals or pharmaceutical players,” mentions Tibrewal, whose mid-cap fund has 5.42% allocation to chemicals, in two stocks — Solar  Industries India and Atul. 

The heat is on
While the going has been good, the valuations between mid-cap and large cap have only widened; the trailing twelve-month price-to-earnings ratio (P/E) of Nifty 50 is around 27x versus 53x for the Nifty Free Float Midcap 100. In terms of one-year forward, Nifty Free Float Midcap 100 is trading at 29x against 18x for Nifty 50. Tibrewal, however, believes investors looking at a longer time horizon (3-5 years), the mid-cap space has ample opportunities for wealth creation, given the expectation of a steep earnings growth. In fact, according to a report by Edelweiss Mutual Fund on mid and small cap fund, a comparison of the price-to-book (P/BV) value of both Nifty 50 and Nifty Free Float Midcap 100 reveals that the mid-cap index is in fact, trading at a ~40% discount compared with Nifty 50. The report explains that the slower pace of earnings, between FY11-16, of both Nifty 50 and Nifty Free Float Midcap 100 firms (3.5% CAGR) vis-à-vis the growth in the nominal GDP (11.5%) reflected the depressed nature of earnings; failing to make P/E an all-encompassing measure to gauge the valuation gap. Another reason for the difference in valuation is the differing underlying sectoral composition of both these indices. With financials occupying major share in Nifty 50 versus the Nifty Free Float Midcap 100, and P/BV being the more appropriate measure to evaluate banks and NBFCs.

Over the past one year, the amount of net inflows into mid-cap focused funds has been over Rs.10,700 crore (till November 2017) against Rs.5,023 crore in CY16. In fact, the cash levels in mid-cap funds is Rs.51,375 crore. Not surprising that Saurabh Mukherjea, CEO, Ambit Capital, states that bull run in the Indian market has to be correlated to retail liquidity; rather than being driven by improvement in fundamentals of small and mid-cap Indian firms. “The whole upward movement in the market has been driven by retail liquidity. And this is how it is in most bull markets...retail money typically drives the final frenzy of a bull market.” Also with the new Sebi ruling on classification of mutual funds stating that 65% of assets benchmarked to mid-cap indices should have their assets mandatorily in mid-cap stocks, there could be more momentum in store. The restructuring of the mid-cap funds will result in a staggering Rs.19,300 crore being pumped into them, as per a CLSA report. 

Against the backdrop of ample liquidity in the space, it becomes all the more crucial to find the structurally driven growth sectors in CY18. Baliga and Tibrewal expect cement to do well in the New Year, as infrastructure projects spur demand for cement. “We don’t see any new capacity coming up, which will lead to a gradual increase in prices during CY18,” adds Baliga. Within the consumer space, the dairy and branded apparel companies are expected to do well, according to Khattar. Baliga also expects the discretionary consumer space to do well, owing to easier availability of credit and lower interest rates. Mehta believes the transition from unorganised to the organised sector, thanks to GST, to augur well for tiles, pipes, plywood and related categories. Mookim, however, adds a rider that while investing in stocks, one needs to classify them into two categories - good businesses and good price. While there are many stocks, which check the first box, barely any, at the moment, check the second.