Why bottom-up approach works best for investing in mid- and small-caps

The BSE mid-cap and small-cap indices are down by nearly 15-20% in the first half of calendar year 2018. The fall in headline indices is far sober in comparison to many individual stocks. The BSE mid-cap index performed well last year, rising around 47%. The benchmark index for small-cap stocks too rose around 58%. Midcaps have outperformed the Sensex for the past three straight years.

Performance of mid-and-cap small caps this year

But mid-and-small-cap stocks have not performed well this year. The concerns about valuations surfaced in 2018. Though there has been considerable amount of correction, most of the mid-caps still appear overvalued. Valuation concerns are substantiated by the fact that the BSE Smallcap index is trading at a price earnings (PE) ratio of 105.35 even as the benchmark Sensex has a PE of 22.86. The BSE Midcap is currently trading at a PE of 31.89.

Measures like additional surveillance mechanism for select stocks coupled with concerns of re-arrangement in classification of mid-and-small-caps resulted in stocks of these two segments underperforming in the first half of the calendar year. However, there are several micro positives of India reflected in auto numbers, higher EXIM, cement and steel volumes, power generation and factory utilisations that indicate major recovery leading to sharp rebound in corporate earnings over the next few years.

Why bottm-up approach is better

There are two approaches to investing in stock markets: Top-down and Bottom-up. Top-down approach is looking at the macros and then industry and company performance; while in the latter the focus is more on the company stock and macros are only looked at from the ratification perspective. Bottom-up approach is ideal for investing in mid-and-small-cap stocks. Midcaps operate on a unique set of economic drivers, which may not be directly connected to the broad macro-economy. It is best to do company specific research. The next few quarters of volatility in equity markets provide an ideal opportunity for long-term investors to enter the segments at favourable risk-reward valuations.

One could look at some stocks in sectors mentioned below. CRAMS: Contract research & manufacturing services, from the global pharma companies is multi-year multi-million dollar opportunity for Indian companies. In the last few years many Indian companies have established the infrastructure, skills and reputation to gain the confidence of global innovators and research companies to outsource their basic research work and eventually manufacturing of successful molecules to Indian companies. We believe some of these companies are now at an inflection point to have high growth of 20% plus per annum for next three to five years.

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Travel and tourism: Aspirations, higher disposable incomes, better connectivity and other infrastructure is driving the leisure travel market to grow in double digits. The airline passenger traffic growth has been at 15% plus per annum for more than last four years. Entertainment for growing kids is a big opportunity in the country.

Rural auto: Indian public transport connectivity in rural areas is fairly inefficient. Companies, which could offer products to have economical transportation system for physical movement of goods & people have a huge market to service.

Infrastructure: Companies with strong balance sheet (low leverage) and operating in infra businesses that generate cash flows are better bets.

Private sector non-banking finance companies: Regional NBFCs having unique selling points in a particular product segment and aspiring to grow in expand have the opportunity to duplicate their success from regional level to national level.

(By Sachin Shah, fund manager, Emkay Investment Managers) 

Source: DNA Money