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Choosing the middle path in equities

Mid-cap stocks are expected to offer better growth potential for their investors than large-cap stocks but with less volatility and risk than that of smallcap stocks. But, don't ignore the caveats.

Raghunath, a software engineer in his mid-30s, has been lately warming up to the idea of financial planning. He approached a financial advisor to suggest him an investment strategy that will make early retirement possible. Based on his current savings rate, he was told to allocate mostly to equity. While embracing equities took him closer towards his retirement goal, it fell short.  

Either he had to save more or choose a higher risk-return proposition to bridge the gap. That’s when the option to invest a small portion of the portfolio in midcap equities was mooted. 

Does it make sense for Raghunath to invest in midcap equity funds?

Mid-cap funds

Let’s understand them first. The top 100 companies in terms of market capitalization constitute large-cap stocks. The next 150 stocks in terms of market capitalization ranking constitute the midcap stocks. Midcap funds invest 65 per cent or more of their portfolio in such stocks.  

Midcap stocks are expected to offer better growth potential for their investors than large-cap stocks but with less volatility and risk than that of smallcap stocks.

Midcap companies, in turn, could be nimble and grow at a rapid clip on a smaller base and by investing back their profits. Contrary to popular belief, many are also niche market leaders – be it Crisil, Godrej properties, Thermax or Voltas. 

Comparing large-cap and mid-cap benchmark indices

Midcap equity index as measured by BSE Midcap 150 TRI has grown more than the BSE 100 TRI over the marginal long-term horizon of 10 years (see chart). Over a seven-year period, the midcap index grew by 13.4 per cent as compared to 9.5 per cent for the large-cap index. 

While there is a strong correlation in the price performance of large-cap and midcap stocks, there are instances when they have moved divergently (see chart) thus giving an opportunity for investors to diversify and protect portfolio losses. Interestingly, it has been seen that midcaps stocks do well during the early bullish phases of the market while underperforming during bearish phases. However, keep in mind that the index doesn’t necessarily reflect the results that the actual funds deliver.

Why include in your portfolio?

Large caps are usually business leaders exhibiting greater ability to withstand economic or geopolitical shocks. However, with mature business models and large operating size, many have to be content with moderate growth in revenues and profits. 

Midcap companies, in turn, could be nimble and grow at a rapid clip on a smaller base and by investing back their profits. Contrary to popular belief, many are also niche market leaders – be it Crisil, Godrej properties, Thermax or Voltas. 

The right extent of financial support and business acumen can catapult these companies into tomorrow’s large-cap. This is where an opportunity lies for investors. 

Share price appreciation is largely a function of the growth in earnings of a company. Historically, midcap companies, on an average, have clocked better growth in profits than large-caps resulting in better performance of their share prices.

Risks

Midcap stocks while safer than small-caps also to tend to be more volatile than large-caps. That’s why you need to have a minimum investment horizon of 7-10 years to makes use of the opportunity.

During economic downturns, they tend to be more vulnerable. Finances usually dry away for them, while a slowdown in business impacts their profits. Unless the company has a robust management strategy, they might not make the cut. 

Choosing funds

That’s why choosing the winners becomes important. Don’t go just by their past returns but also look at its performance consistency– over five, seven and 10-year period. 

Choosing a market-beating mid-cap fund is a tougher proposition, thanks to huge divergence in its performance. This is why when it comes to choosing actual funds mid-cap fund performance can be barely better than large-cap funds. The dispersion of five-year returns of large-cap funds was 26 per cent of its mean as against 53 per cent for midcap funds. Simplistically put, it means that a wrong choice can lead to larger potential losses. 

Has it done well because of stellar returns of a few stocks or is it because of all-round performance?  Is the fund house doing well on the equity front? Do the necessary due diligence on these aspects.

Takeaway

Midcap funds have the potential to improve overall portfolio returns if you are able to absorb their higher volatility and also select the right fund as fund choice can influence growth rates immensely. A calibrated exposure in them can accelerate progress towards your goals. 

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