Mid-Cap Funds to Outperform Blue-Chip Funds

Hit hard when stockmarkets were battered last year, laggard equity funds focused on India's small and mid-cap stocks are likely to outperform their larger peers in the next three years as risk appetite returns in the wake of the election victory by the reform-minded Congress party.

Small and mid-cap stocks in sectors such as real estate, and especially low-cost housing, housing and infrastructure have already been rising more than their larger counterparts in the past few weeks on expectations of a continued decline in interest rates, improved liquidity and infrastructure investments by the government.

"A lot of these small-cap stocks were beaten down more than their large-cap peers as rising costs and a liquidity crunch hurt," said Mohit Mirchandani, head of equity investments at Taurus Mutual Fund, which had average assets under management of 5.97 billion rupees ($127.8 million) as on May 31, 2009.

"But as confidence among investors grew and risk appetite returned, we have seen these stocks jump and in a rising market like the current one, this outperformance could be sustained," he added.

Fund managers said Congress's victory should bring policies that promote investment and create an investor-friendly economic environment.

Since May 18, the first trading session after election results handed a clear mandate to the reform-friendly Congress-led United Progressive Alliance, smaller stocks have outperformed the benchmark index. The Bombay Stock Exchange's Sensex has risen 21.9% between May 18 and June 1, while the BSE Midcap Index is up 36.7% and the BSE Smallcap index has surged nearly 45%.

But last year, while the BSE Sensex fell 52.4% in the wake of the credit-crunch, the small cap index plunged 72.4%, and the mid-cap index lost 67%. Manish Sonthalia, a fund manager at Motilal Oswal Securities, said that the valuation gap between large cap and small cap stocks will contract as the room for upside in small- and mid-cap stocks is still much higher.

"I feel good mid-cap stocks have the potential to grow earnings at 30%-40% annually for the next three-to-four years, mainly due to a lower equity base compared to large-caps," said Amar Pandit, chief executive of Mumbai-based private wealth management firm My Financial Adviser, referring to how earnings per share at companies with smaller equity float tend to be higher.

Suhas Sumant, a fund manager at Sharekhan Ltd., said small and mid-cap stocks, and thus funds, should gain 30% to 40% annually in the next two-to-three years, compared with blue-chip stocks, which should only go up around 15%-20%.

Large-cap stocks are trading at a price-to-earnings ratio of 16 to 18 times one-year forward earnings, well above the 4-8 times small and mid-cap stocks are trading at, Mr. Sumant said.

A survey of more than 175 mutual funds by Value Research shows that mid-cap funds have generated an average return of 35.57% in the month of May, due to the election win, while small-cap funds have returned 45.71%.

In comparison, large-cap mutual funds have returned just 28.06% on average in the month. Still, the downside for smaller stocks is also greater than that for large-caps in a slumping market, as evidenced by last year's performance, said Dhirendra Kumar, chief executive officer at Value Research, an independent provider of investment information on mutual funds.

"The higher the reward, the higher the risk," he said.

Deven Choksey, managing director at K.R. Choksey Securities, said some "quality-mid cap ideas" include stocks like infrastructure projects financing firm Infrastructure Development Finance Co, state-owned lender IDBI Bank Ltd., construction company JMC Projects India Ltd., and power equipment maker Areva T&D India Ltd.

Mid-cap and small-cap stocks chosen by funds should work not just on the valuation front, but also have good business fundamentals, strong management and growth potential, said Value Research's Mr. Kumar.