After years of admirable performance, the mid-cap segment turned tail. Since the peak hit in January this year, the Nifty Midcap 100 index has lost 13%. In contrast, both the Nifty 50 and the Nifty 100 index have lost 3%. Is this slide worrying? What should you do with your mid-cap funds?
Lack of corrections
Step back and look at what mid-cap stocks – and small-cap stocks, for that matter – offer. In years such as 2007 and 2009, for example, the Nifty Midcap 100 index returns were over 20 percentage points more than the Nifty 50 or the Sensex. 2007 was a year of peak economic performance and 2009, right after a market crash. But in correcting markets of 2008 or 2011, the Nifty Midcap 100 declined over 10 percentage points more than the Nifty 50 or the Sensex. The chart below shows the calendar returns of various indices.
Now look at the years between 2014 and 2017 – mid-caps have in every year beaten the large-cap indices. The elections in 2014 and the promise of reforms, improved policy decision-making, and resumption of sluggish growth that it indicated sent markets soaring. Until January this year, markets were unfailingly optimistic on economic and corporate growth recovery. The additional spur of liquidity through domestic and foreign institutional investors also kept markets up.
Up until 2015, indices tended to follow the same general trend – i.e., mid-caps and large-cap indices would both move up or both move down. However, the past few years has bucked this trend.
- Large-caps had bouts of corrections that were not matched by mid-caps. In late 2015, for example, global markets corrected on fears that a slowing China would pull growth down. Large-caps were hit more in this correction, even as the midcap index ended on a positive note that calendar. After the short-lived correction in 2016, the bounce back that the midcap index charted was huge and this quickly compensated for the brief falls. Rolling 3-month returns since 2014 shows that the large-cap indices have had a larger proportion of corrections than the mid-cap index.
- Mid-caps have run up much more than large-caps. Apart from the lack of corrections, mid-caps have also generally seen a sharper price run than their large-cap counterparts. Higher liquidity, especially from institutional investors, led to several sound mid-cap companies being unearthed. Between May 2014 and the peak in January 2018, the Nifty 100 gained an absolute 60% return. The Nifty Midcap 100 rose 110%.
- The gap between mid-cap and large-cap valuations has only widened. The price run-up coupled with comparatively sedate profit growth has seen the Nifty Midcap 100 PE multiples climb much more than the Nifty 50. The gap between the two has steadily widened. Generally, valuations tend to correct when the gap between large-cap and mid-caps get high.
So what’s the implication of this trend? One, mid-caps generally tend to fall more than large-caps when markets correct. This has, however, not been the case over the past four years. Mid-caps also haven’t had an extended corrective phase and have seen limited volatility, unlike large-caps. This divergence is now being addressed. In the correction since January 2018, mid-caps have finally dropped more than large-caps on a sustained basis. Year-to-date, the Nifty Midcap 100 index is on a 10.5% loss against the 2.4% return of the Nifty 50.
Two, while mid-caps have outperformed, earnings have not kept pace. Larger companies are also seeing better revenue and earnings growth. Excluding banks and financial companies, companies with a marketcap of over Rs 20,000 crore have seen revenues grow over 10% in the past two quarters. Companies with a Rs 5,000-Rs 20,000 crore marketcap have seen a 2% revenue growth in the March 2018 quarter and a slight decline in the December 2017 quarter.
Midcap fund performance
With the mid-cap segment correcting, mid-cap funds have seen their returns also dip. Mid-cap funds (as per FundsIndia’s old category) saw their double-digit returns slip into single digits in the correction. Year-to-date, the mid-cap category average is a loss of 6.8%; 6-month returns are also in the negative zone. This contrasts to the 1.3% average loss of the large-cap category and the still-positive 6-month returns. In fact, 1-year returns for several large-cap funds are now better than mid-cap funds.
But while mid-cap fund returns are dropping, their performance relative to the market is actually improving. Average returns for mid-cap funds had been trailing the Nifty Midcap 100 by a wide margin over 2017. This was a result of several factors – funds began turning cautious given the price run-up in the space and the lack of reasonable valuations and they began to include a higher share of large-caps. Several stocks that shot up in the year also did not have strong fundamentals, and funds therefore stayed away.
This caution seems to have paid off. In the correction since January, mid-cap funds have managed to contain declines better than the Nifty Midcap 100 TRI index. So in 2017, while just about 25-35% of the funds were beating the index, the figure is now 65-70%. Funds such as Franklin India Prima, Invesco India Midcap, IDFC Multicap, HDFC Midcap Opportunities, Sundaram Midcap, all of which were trailing the index for the bulk of 2017 have now moved above.
Ability to contain downsides is a key metric for funds, especially in the mid-cap space where falls can be steep. On this count, mid-cap funds in the Select list have generally been adept at containing downsides. Using the capture ratio, which measures how much of an index’s movement a fund captures, the Select list mid-cap funds have mostly been better than average. A lower capture ratio in correcting markets means the fund is falling lesser than the benchmark.
|BNP Paribas Mid Cap||69.8|
|Franklin India Prima||52.9|
|HDFC Mid-Cap Opportunities||59.0|
|L&T India Value||69.6|
|Mirae Asset Emerging Bluechip||54.0|
|Principal Emerging Bluechip||66.7|
|Sundaram Mid Cap Fund||75.6|
|*Capture ratio based on 1-month rolling returns for 5 years|
Therefore, while mid-cap indices are correcting, some comfort can be drawn from the fact that funds are able to contain losses better. Recovery, when it happens, will therefore be faster. The correction will also help bring valuations into more reasonable zones, which can allow funds buying opportunities. Of the mid-cap stocks making up the Nifty 500 universe, more than three-quarters have fallen more than the Nifty Midcap 100 index.
What should you do?
In our equity outlook for this year, we had called out the lack of volatility in the market, the market’s apparent disregard for near-term risks, and the headwinds facing the markets this year. Volatility has now returned to markets, with the return deviation so far this calendar close to the levels seen in 2013-2014. The market is also taking cognisance of risks stemming from rising crude oil prices and inflation, interest rates domestically and overseas, a squeeze in foreign institutional liquidity, and the various state and general elections.
Large-caps are better placed at this point, both from a valuation and growth recovery perspective. In an inflationary scenario, rising input prices and a potential rise in interest rates too, larger companies are better positioned than smaller ones. Therefore, drivers for further price rise in mid-caps are limited in the near term.
- If you hold mid-cap funds, continue to remain invested. Long-term drivers for economic and market growth, also detailed in the equity outlook hold good.
- If you have SIPs running in mid-cap funds and the allocation to mid-caps in your overall portfolio is limited, continue with the SIPs. Given the lack of meaningful correction in the past 4 years, this period will help average costs down. If mid-cap allocations are high, redirect SIPs in large-cap or diversified funds.
- If mid-cap allocation in your overall portfolio is higher than 25-30%, consider adding to the large-cap or diversified space to bring down the impact of the mid-cap allocations.
At the end of the day, remember that mid-cap funds require the ability to take high risk and pull through corrections. Don’t let the steady price rise of the past four years lure you into forgetting that mid-caps are high-risk in exchange for their high return.
FundsIndia’s Research team has, to the best of its ability, taken into account various factors – both quantitative measures and qualitative assessments, in an unbiased manner, while choosing the fund(s) mentioned above. However, they carry unknown risks and uncertainties linked to broad markets, as well as analysts’ expectations about future events. They should not, therefore, be the sole basis for investment decisions. To know how to read our weekly fund reviews, please click here.
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