FINANCIAL CHRONICLE, MONDAY, MAY 6, 2013 - PAGES 4

TREASURE HUNT
The massive bear hammering of midcap and smallcap stocks creates ground for investors to hunt for potential multi-baggers
RAJESH ABRAHAM
FTER THE near-collapse of several midcap and smallcap stocks, there is a feeling that this may be the right time to hunt for good stocks amid the rubble. From their all-time high levels in 2008, the BSE midcap index is down 37 per cent, while the BSE smallcap index is down 57.63 per cent. In comparison, the broader market index, Sensex, is just 7.69 per cent away from its alltime high recorded in January 2008. In the recent collapse, several midcap stocks became smallcaps and smallcaps turned into penny stocks. The reasons for the flight of investors from these stocks range from corporate governance issues, mismanagement and share pledges by promoters to unviable business prospects as the general economic condition worsened. Broking outfit Espirito Santo identified some reasons for the collapse of the mid-cap and smallcap stocks. First, profitability erosion in smaller companies has been far worse in this cycle, with poor pricing power making it difficult to pass on higher input costs. Secondly, the midcap stocks have sharply increased leverage in a high interest rate environment, with aggregate net gearing rising from 60 per cent in FY08 to 90 per cent at present. Another reason is that foreign institutional investors (FIIs) ownership of midcap and smallcap stocks is less, even though they have been the only buyers of Indian equities for some time now due to the difficulties faced by domestic financial institutions. And finally, corporate governance is more patchy in smaller companies, especially in stocks with very high level of promoter ownership (as per Espirito Santos analysis, stocks with less than 76 per cent promoter holdings are among the worst-performers over the past 10 years). Still, experts believe that there are big opportunities in these two categories of stocks, as some good quality scrips may have also fallen due to a side effect of the meltdown in smallcaps and midcaps. This is precisely why IDFC Mutual Fund recently launched a three-year close-ended fund aimed at smallcap stocks while two other fund houses, Axis Asset Management Company and Union KBC AMC, have filed documents with Sebi to launch a smallcap fund and a small and midcap fund, respectively. R Sivakumar, head of fixed income and products at Axis Mutual Fund, said several stocks benefited when the investment cycle turned, albeit temporarily, in 2009-10. He reckoned that there was a similar opportunity now for investors who are willing to be patient in the medium term. From a high of 10,245.81, the BSE midcap index collapsed to 3,235.05 in 2008 and further to 2,547 in early 2009, before clawing back to 7,802 in 2010, a gain of 206 per cent from

the lowest point. Likewise, the BSE smallcap index recovered from the low of 3,268 in 2008 to touch 9,670.31 in 2010, a gain of over 195 per cent! A similar comeback cannot be ruled out from here on. Apurva Shah, head of investment research at BNP Paribas Mutual Fund, said there were

several opportunities in the smallcap and midcap segments. However, he had a word of caution for investors; the opportunity is not across the board and investors should be selective and sensible about it. Dont fall into the trap of buying a stock simply because it has fallen too much. We follow a bottom-up approach to pick smallcap and

midcap stocks. That, and strict adherence to the investment philosophy of buying only high quality businesses run by competent and ethical managements has held us in good stead. Long-term investors should most certainly look at investing in midcap funds at these levels, he said. Broking outfit Espirito Santo Securities said

in India the real bear market this year is in the midcap and smallcap stocks, which have underperformed Sensex by 11 per cent and 18 per cent, respectively. It said the mayhem in these stocks was due to a confluence of several technical and fundamental factors. While this bear-hammering may continue for some time, all mid-caps shouldnt be tarred with the same brush, Espirito Santo analysts led by Nick Paulson-Ellis, said in a note. We think the recent correction creates a potential mispricing opportunity in several stocks just ahead of a turn in the economic cycle. We have selected stocks that we believe would avoid the current midcap pitfalls, offering 20 per cent plus potential upside with defensible margins, low levels of pledging, sound balance sheets and no major governance issues. They are LIC Housing Finance, Bayer CropScience, Coromandel International, Oriental Bank of Commerce, Max India, KPIT Cummins, Federal Bank, Gateway Distriparks and Motherson Sumi, the note said. The problems faced by smallcap and midcap stocks mentioned above should be considered carefully and they are not going to change overnight. But they do not affect all midcaps equally and we think the recent underperformance presents an opportunity to enter into strong long-term structural stories at reasonable valuations. There are plenty of studies across markets showing that smallcaps/midcaps outperform large-caps in the long term, and the same is true in India too the 10-year compounded return of CNX midcap is 23 per cent compared with 20 per cent return on the Sensex. The four listed companies with 60 per cent plus returns (compounded annual growth rate) in the past 10 years were all mid-sized firms. Also, the number of mid-sized firms that provided 50 per cent plus returns (CAGR) in the last decade is 4.5 times the number of largecaps, Espirito Santo said. Fund managers at IDFC Mutual Fund also expressed confidence in a comeback of smallcap stocks while launching its three-year closeended fund. Said Kenneth Andrade, chief investment officer of IDFC Mutual Fund: In the last 10 years, the period between 2005 and 2007 was the best one for India Inc, whereas the smallcap index created maximum wealth in 20032005 while the ROE touched 19.91 per cent only in 2005, indicating that smallcap companies are the ones whose valuations get impacted in case of a reversal in the economic cycle. Since then, the ROE has fallen to hit a low of 13.2 per cent in 2012, indicating that a reversal in the economic cycle is around the corner, Andrade said. It is time to search for life in the debris. Surely, there are several multi-baggers waiting to be picked.
rajeshabraham @mydigitalfc.com

Now playing on D-Street: A hare-and-tortoise story

AMIT MUDGILL

HE MARKET may have climbed over 130 per cent since it hit its multi-year low in early 2009 following the meltdown of the US financial market, but the post-Lehman turmoil has taught domestic investors one lesson defensive stocks are a must to balance a portfolio. The interest generated in these stocks has led to the doubling of their weightage in the benchmark Nifty index. Defensives are in vogue again after the financial crisis, as economic growth has slowed down. If one is willing to look beyond a normal time horizon of professional money managers, both FMCG and healthcare sectors offer fantastic long-term investment opportunities for riskaverse investors who want to build asset in the long run. The allocation depends on individual circumstances, but personally, setting aside a portion of your money for such investment is a very wise thing to do, said Nobutaka Kitajima, chief investment officer for equity at LIC Nomura Mutual Fund. Eight Nifty constituents ITC (9.46 per cent), HUL (3.15 per cent),

Sun Pharma (1.88 per cent), Dr Reddys Labs (1.35 per cent), Asian Paints (1.11 per cent), Cipla (1.08 per cent), Lupin (0.88 per cent) and Ranbaxy (0.37 per cent) together carried 19.28 per cent of index weightage as of April 30. This is double the 8.54 per cent weightage that five defensive stocks commanded in the index at the end of calendar 2009. The fact that FMCG and pharmaceutical sectors are non-cyclical in nature made these counters attractive bets in both good and bad times. By the end of 2010, Dr Reddys Labs got added to the defensive basket and their total weightage in Nifty rose to 10.54 per cent. At the end of 2011, the weightage of the same set of stocks climbed to 14.97 per cent. Asian Paints and Lupin two other defensive stocks were later included in Nifty during 2012, and the total weightage of the defensive basket rose to 17.37 per cent at the end of December 31, 2012. The exchange started calculating Nifty weightage based on the free-float methodology with effect from May 4, 2009. Since then, the weightage of the defensive sectors has kept on rising. The bourse discontinued publish-

ing daily weightages of the index constituents with effect from Thursday. On pure returns parameter, FMCG major ITC has given consistent returns over the past four years. The stock gave 49 per cent return in 2009, 44.35 per cent in 2010, 18.05 per cent in 2012 and 45.20 per cent in 201e. Year-to-date, the stock is up 13.09 per cent so far. The stock lost 16 per cent in 2008, the year of global turmoil, against a sharp 51.79 per cent slide in the benchmark Nifty. ITC has beaten Nifty in terms of yearly return in six out of the past 10 years, giving negative returns on just one instance, 2008. Nestle was the worst performing FMCG stock in 2012 with a return of 19.59 per cent. It gained 63 per cent and 49 per cent in the two preceding years, respectively. United Breweries, United Spirits, GCPL and Colgate-Palmolive gained 470 per cent, 241 per cent, 179 per cent and 140 per cent, respectively, over the past three years. Pharmaceutical stocks were not far behind. In fact, Wockhardt, Strides Arcolab, Ipca Labs and Sun Pharma have given between 170 per cent and 640 per cent returns over the past

three years. Stock prices of Cadila Healthcare, Lupin and Glenmark Pharma have doubled during these years. The BSE healthcare index constituting 17 stocks rose 38.53 per cent in 2012, declined 12.36 per cent in 2011, gained 33.28 per cent in 2010 and was up 70 per cent in 2009. Kitajima pointed out that share price movements and fundamentals of companies can differ significantly over a longer time frame. If one looks at the US consumer staples sector, which includes some of the big names such as Altria Group, PepsiCo, Coca-Cola, and Walmart, all of them more than quadrupled in the 1990s as measured by the S&P500 consumer staples index. However, the sector did nothing for the next 10 years in 2000s, although investors had received reasonable dividend payout during this period as the companies continued to generate cash and grow their book value, he said. The price-to-earnings ratios of some of these domestic defensive stocks remain as high as 45, while broader index Nifty is trading at 17.89 times its trailing 12-month earnings per share. However, steady earnings by these sectors over the past few

years have to some extent removed these fears. Analysts pointed out that the FMCG sectors average valuation is now at around 25 times FY15 forward price-to-earnings ration. Akshay Gupta, chairman and managing director at Peerless Mutual Fund, believes that the co-called defensive sectors are a typical hareand-tortoise story; these sectors walk slow but steady. FMCG and pharma are among the tried and tested sectors. They have offered an average of 15-16 per cent topline growth over the past many years. If we see Indian demographics, nearly 70 per cent of our population is under 35 of age. In the past, investors had underestimated the growth opportunity in the defensive sectors and were more focused on sectors such as infrastructure. We believe the consumption story will remain intact over the next 10 years. We are bullish on these sectors, he said. Cyclical sectors could outperform these counters only when the government unleashes a serious round of reforms, Gupta said. Firms from the BSE FMCG index and BSE healthcare index had an

average institutional holding of 32.60 per cent at the end of the March quarter, up from 31.66 per cent in the year-ago period. This is in contrast to an average of 21 per cent institutional holding in BSE realty index and 25 per cent in BSE capital goods index. Most mutual fund managers too have shown a preference for defensive stocks. Dr Reddys Labs features in the portfolios of schemes such as Franklin India Flexi Cap (8 per cent), ICICI Prudential Focused Bluechip Equity (2.75 per cent) and Morgan Stanley Growth (3.56 per cent). HUL figures in the portfolios of HDFC Top 200 (1.77 per cent), DSPBR Top 100 Equity (2.22 per cent) and Franklin India Bluechip (1.42 per cent). Sundaram Taxsaver (5.32 per cent), HDFC Growth (3.17 per cent), Reliance Regular Saving Equity (3.10 per cent) have exposure to Cipla. Mutual funds exclusively focused on FMCG and pharma stocks have given between 22 per cent and 28 per cent returns over the past one year, which was highest among various mutual fund categories.
amitmudgill @mydigitalfc.com

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