Do you know what is common between Astral Polytechnik and Eicher Motors?
These market leaders today, were ‘mid-cap stocks‘ a decade ago.
And how they have evolved!
Not many could have thought, CPVC pipe technology (which was 30% costlier at that time) could replace Galvanized Iron (GI) pipes, the norm in the piping industry.
Only a few investors were ready to bet on a disruptor like Astral.
But the company went a step further and did the unthinkable. It successfully created a brand out of a commodity: pipes.
No wonder it enjoys the price to earnings ratio of a FMCG company.
Or let’s consider Siddharth Lal. This young entrepreneur was given a deadline by the board of directors to turnaround the loss making Royal Enfield.
Royal Enfield sales went up from 50,000 bikes per year to more than 65,000 bikes per month currently!
The company which was a premium player carved out a niche for itself in the two wheeler industry.
It was a farfetched idea to export premium leisure bikes like Royal Enfield to developed countries like USA and Europe where the giant Harley Davidson was the undisputed king.
Siddharth Lal and his team made that happen by launching new bikes with higher horse power (>500 cc) for the export markets. Exports now account for about 7-8% of sales.
What a great brand following and cult Royal Enfield has created for itself…
Let’s do some fun math on Royal Enfield.
A Royal Enfield bike purchased in 2010 would have cost you Rs 84,000. The same amount put in Eicher Motors stock would have fetched you Rs 2.5 million (m)!
A whopping 30x returns in a decade.
With that much money you could not only go bike riding to the Himalayas but also purchase a house in the hills.
That’s the power of investing in good quality mid-cap stocks.
But why am I giving you this analogy?
I am sure after the ruthless slaughter of small and midcaps in 2018, you would prefer sound 15% compounders.
Our minds are programmed to like consensus stocks. Herd investing mentality makes overvalued stocks look safe.
And why not? After all, safe is good, right?
Well, in that case let me make a compelling case for investing in mid-cap stocks.
Here are straight points backed by data. No theories or conjectures.
In a slowing economic growth scenario, the strong (largecaps) gets stronger while the weak (small and midcaps) wither out.
Let’s look at economic growth…
When the economy faces headwinds it’s the strong companies (large-cap stocks) which gain market share. That is exactly what happened post 2017.
2017-2019: A Period of No Returns
Stock prices are slaves to earnings. The GDP growth rate post 2016 has been on a downward trajectory. The same has been mirrored in midcap returns post 2016.
The midcap index delivered a 0.6% CAGR over the 3 year period while the Nifty 50 outperformed with a 12% CAGR.
What a contrast. The reason was poor economic growth which benefitted largecaps and not midcaps.
The period 2020 to 2021 was an abnormal year mainly on account of sharp decline in interest rates which led to sharp rise in all asset classes across the globe.
It doesn’t make sense finding a corelation as it was an anomaly on account of the pandemic.
Fast forward to 2022
Now that things have normalised, it was the largecaps which outperformed and not the midcaps.
While interest rate hikes was the main reason, it was also on account of slower earnings growth among midcaps as compared to their largecap peers.
So, the Billion Dollar Question Is: Where Are We Now?
Rather the more pertinent question…
Interest Rate Hikes: Are We Close to the Peak?
While 2020 and 2021 saw cost of capital at one of its lowest levels, risky assets like stocks outperformed. It was like adding fuel to a burning fire.
This led to all stocks irrespective of fundamentals going up. The run up was led by strong narratives and not fundamentals.
However, 2022 humbled many investors on account of increase in interest rates by global central banks.
In a declining interest rate scenario, small and midcap stocks are the biggest beneficiaries as the cost of equity comes down drastically.
On the contrary, as interest rates start to go up, it is the largecaps which benefit. Money flows from risky assets to less risker assets in the equity market i.e. from small and midcaps to largecaps.
That is precisely what happened over the past 1 year.
The midcap index declined by 2% while the largecap index Nifty grew by 6% during the same period.
As the cost of debt started going up, interest costs of small and midcap companies went up leading to pressure on profitability.
However, in my view all of this is set to change in favour of midcaps as interest rates are likely to peak over the next 6 months.
This will lead to higher economic growth as inflation comes under control.
If you don’t believe me, consider what happened during 2003-2007 era.
While the economy grew at CAGR of 9% during the period, Nifty grew by a whopping 50% CAGR.
But mid-cap stocks delivered a whopping 68% CAGR.
Markets discount these things in advance.
When the interest rates peak and start to go down eventually, midcaps will outperform first followed by smallcaps.
The macro headwinds are likely to abate.
That’s why I say catch them young!
Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such.
This article is syndicated from Equitymaster.com
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