Stock market investing is a paradox. You can make money in stocks, perhaps better than any other asset class. Or you can lose it all, perhaps more than your savings. You don’t have to look too far for proof. Take a look at mid-cap returns.
Until the second half of calendar 2017, nothing could go wrong with mid- and small-caps. But how things have changed. The BSE Mid-cap index lost Rs 1.91 crore in market value in barely six months. Reliance Communications, Adani Power, Bank of India, Union Bank of India, Bharat Electronics are some of the prominent losers drop 42-62 percent in the last six months. HPCL, Mangalore Refinery, Reliance Power, GE T&D followed as their stock prices tumbled due to a huge-sell off in mid-cap stocks.
The carnage is more widespread in stocks that are not part of the indices. Everywhere you look there is a sea of red in the mid-cap. Overall, nearly 72 percent of mid-cap stocks have given negative returns since January. In other words, two out of three shares have dropped in value.
Now, will mid-caps still deliver sky-high earnings?
People invest in mid-caps to chase alpha or to beat the market growth. Since stock values are contingent upon earnings, looking at mid-caps just from the earnings perspective can be misleading.
For example, assume a mid-cap will grow at 50 percent growth rate. But if the stock is trading at 100 times earnings, it will take three years for price earnings to reach reasonable levels of 30 times earnings. Or four years to reach a PE level of 19 times earnings.
In reality, mid-cap stocks will appear realistically priced only if their PEs are around levels of 20-30 times earnings.
So, if the earnings outlook is not optimistic, even a lowly priced mid-cap stock might appear quite pricey.
On the contrary, a high-priced large-cap stock may not be as expensive because they exhibit more stable growth rates. More importantly, their earnings are visible. Moreover, they will be able to ‘realise’ these future earnings, as opposed to many mid-cap companies that have to ‘invest’ either in business or capital expenditures on plants, marketing, systems, and to improve efficiency in operations.
In other words, sky-high earnings growth is being priced when stock valuations get lofty. The question therefore to ask is whether mid-caps will be able to grow at faster earnings growth of say over 30-40 percent for a reasonably long period of time of four-five years. If it’s not possible, then mid-caps can be quite pricey.
Many investors rely too heavily on past performance when deciding which stocks for investments. While that is a good indicator of the friendliness of management, it rarely indicates how the stock will perform in the future.
You have to look at each company’s investment prospects differently. That is, how they plan to overcome the challenges of increasing revenues in a slowing economy or the rising costs of doing business.
A chapter never before
Individual stock picking is getting trickier. Some of the best stocks have not been making money for investors, while some of the fallen stocks have rocketed ahead. While the Sensex is on a tear, mid-caps and small-caps are losing money. Smart money is getting increasingly choosy, and is dumping some many a good companies.
Understand when people sell stocks. Normally, it’s for one of two reasons: cashing out or it’s a turn in sentiments. People sell when the markets are extremely favorable, or when the market’s risk tolerance levels have reached a peak.
In Indian markets now, both are under play.
Your only strategy now: stick to the better-known, well-managed large caps, and wait for the churn in mid-caps to get over. If you want to buy mid-caps, choose carefully – and bide your time. Some low hanging fruits have dropped lower.
