MUMBAI - The Indian stock market has been
bustling with activity in the past few weeks.
Surprisingly, the excitement seems to be more in the
mid-cap segment (shares of medium-sized companies) whose
average returns far exceeded those of other stocks.
The scorching pace set by Indian mid-cap stocks
has left global peers far behind. With a massive 27.81%
gain in the June-September period, the Indian CNX Midcap
200 has outperformed its ilk in the United States,
Europe, Japan and Australia by a wide margin. The only
other such index that has just about managed to cross
the double-digit mark in terms of percentage gains is
the Australian one, with a gain of a little over 11%
during the same period. The Brussels and Barcelona
indices rose by 7.94% and 5.55%. In the US, while
frontline stocks have rallied in the last few weeks, the
mid-cap index has been very subdued. In France, mid-caps
just about managed to stay afloat while those in Japan
yielded negative returns.
But is this rally
purely technical or has it been driven by fundamentals?
It's a mix of both. Evidence does point to the emergence
of strong fundamentals, apart from some technical
reasons. The capital market and the regulatory
environment In India have seen a lot of changes over the
past few years. With the liberalization policies set
rolling in the 1990s, competitive pressures have
increased and tariff protection has come down over the
years. The result: a more efficient system with a
reduced risk of systemic failure and a far more stable
macro-economic environment.
With continuing
reforms and high economic growth, a variety of
opportunities have opened up for Indian companies. There
are several reasons behind the rush for mid-caps. The
winners in the mid-cap segment are set to evolve into
large-caps in the years to come and thus create
long-term wealth. According to a study by Cholamandalam
mutual fund, of the top 50 stocks in terms of market
capitalization, as many as 20 were mid-caps seven
oreight years ago. This is a natural process of
evolution of companies in a dynamic and fast-growing
economy like India's.
Proving wrong the fear
that Indian companies would be washed away in the flood
of global competition following reforms, many mid-cap
companies have actually emerged much stronger. And, seem
to be on pretty strong footing, with the Indian economy
poised for a 6%-plus growth rate in the years to come.
There are also enough reason to expect a surge in
domestic demand. These are:
Young population. With only 17.4% of India's
population above 45, India is among the youngest nations
in the world.
Distinct change in the Indian family structure, from
the joint to nuclear family systems. This entails a
larger number of consuming household units.
With the increasing importance of the service sector
in India's gross domestic product (GDP), the total
number of households with a higher propensity to spend
has been increasing rapidly.
Steadily decreasing domestic interest rates and
increasing focus on retail lending by banks and
financial institutions, which have fuelled higher
consumer spending.
According to DSP Merrill
Lynch, India has the potential of doubling her GDP to $1
trillion by 2010, backed by strong domestic demand. This
is expected to lead to the creation of a million jobs
per year. Many of the mid-cap companies are well poised
to take advantage of this likely change in the domestic
scenario.
Fundamentals apart, the mid-cap rally
is also fueled by technical factors. Historically,
mid-cap companies have a higher return profile than
large-cap companies. Being neither small nor large,
mid-cap firms have attractive risk/return profiles.
Again, the mid-cap segment offers a variety of stocks.
There is a large and diverse group of companies to
choose from among the mid-cap universe of stocks, which
enables investors to create a well-diversified
portfolio. Unlike large-caps, many of these companies
are under-researched and provide opportunities for being
identified as undervalued companies.
Mid-cap
stocks that are relatively "under-owned", or owned by
fewer people and less talked about, give much higher
returns than "over-owned" stocks. If a stock is
under-owned, it is chased by fewer people and thus sells
low. Over-owned stocks, on the other hand, are the ones
everybody wants, most often overvalued and offer little
upside as there are too many sellers at every price
rise.
Foreign institutional investors have also
contributed largely to the demand for mid-caps. The FII
stake in the top 50 stocks in terms of market
capitalization has already crossed 20%, leaving little
room for them to buy large-caps. As a result, they are
increasingly investing in mid-cap stocks. Currently, 20%
of the incremental foreign institutional flows come into
mid-caps, compared to about 5% about three years ago.
As mid-cap stocks surge, the future return
potential gets capped. Moreover, as increasing demand
makes the mid-cap companies increase their capacity
utilization, the need for further capacity expansion
will affect their margin in the future. But for the time
being, the story still looks good.
Kunal
Kumar Kundu is a senior economist with a leading
bilateral Chamber of Commerce in India. He has a Masters
in Economics with specialization in econometrics from
the University of Calcutta.
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