Now, let us take a look at the list of contenders in 2007, i.e., mid-cap stocks with a market capitalization in the range of $2 to $5 billion, which had the promise to grow into large-caps by now. Out of the 73 contenders, only 14 have managed to move up the ranks to become large-caps, while 41 stocks actually slipped below the threshold of $2 billion market capitalization.
Stocks lose momentum for a variety of reasons. Many are able to grow spectacularly well when they start off from a small base. As size catches up, it becomes difficult to maintain the elevated rates of growth. Often constraints are imposed by the size of the business opportunity, the competitive intensity or the need to continuously reinvest cash flows. In some cases a de-rating may be caused by management action such as a bad acquisition or unrelated diversification. Or some stocks may just fall victim to cyclical swings in the economy.
Many mid-cap funds are launched with the marketing pitch that smaller companies will be able to compound their market caps faster. However, a look at the mid-cap indices suggests that over the last five and 10 years, the mid-cap indices in India have barely managed to outperform the frontline large-cap indices. On a risk-adjusted basis (as measured by the Sharpe ratio—a ratio used to evaluate the performance of an investment while adjusting for risk) the large-cap indices have given similar returns with lower volatility than the mid-cap indices.
This raises the question of whether mid-cap investing in India is more about getting the sector themes right rather than buying stocks with a view that they will secularly graduate to becoming large-caps.
The data quoted earlier does prove that linear extrapolation of stocks from mid-caps to large-caps is more an exception rather than a rule. If an investor is able to make early bets in themes that catch the fancy of the markets, and rotate out of them into newer themes before the old one fades out, one can make outsized returns. But this involves superior insight and great timing. And of course, if one is able to pick the secular winners from this group, the rewards are spectacular.
But more often than not, investors end up chasing mid-caps that are already “hot” where the odds are low that future returns will continue to sustain for the medium to long term.
To conclude, investors should recognize that attrition is often the rule rather than the exception when they seek to discover the giant sequoias in the stock market.-wrote Amay Hattangadi/Swanand Kelkar,Morgan Stanley Investment Management