Are midcap stocks on the road to revival in 2020?

Aditya Khemani

Before I try to answer the question in the headline, let us understand under what economic conditions midcap stocks do well.

We all know when the economy is doing well, most companies shine. When economic condition worsens, a midcap company's ability to withstand a shock is lower than that of large cap companies. Hence, its business becomes more volatile, cash flows get impacted, which in turn affects   earnings growth.

However, exceptions to this general rule do exist where smaller companies enjoy a dominant position and still do well in a weak economic environment also. To put the numbers in perspective, over the past eight quarters, the Midcap 100 index reported an earnings decline of 6 percent. In such a situation, investors then reduce midcaps and add largecaps, thus leading to midcaps underperforming.  So, in an environment of weak economic performance over the past 18 months, midcaps have underperformed sharply.

From the start of 2018, the Nifty is up nearly 10 percent while the Nifty Midcap is down close to 20 percent and the Nifty smallcap has come off by about 35 percent. However, even after the recent underperformance, over a longer period of 10 years, the Midcap index has managed to perform exactly in line with the benchmark Nifty.

As I write this, economic data points continue to very weak, but the seeds of recovery are being sown. We have seen the Reserve Bank (RBI) cut repo rate by around 1.35 percentage points since February 2019, but the lending rates have been cut by around 0.35-0.40 percentage points only as deposits re-price with a lag. Hence, one could see around 1 percentage point lending rate cut by banks over the next 12 months.

Commodity prices, including those of Brent crude, have been lying low, which is a positive for India. Plus, we have also seen the monsoon being very good this year, which will lead to some uptick in the rural economy, which has been under some stress.

More importantly, investors had started doubting the urgency on part of the government to revive the economy. But the recent corporate tax rate cut, along with the other measures, is a clear signal of the new-found urgency amid a pro-growth stance. As equity markets like the growth approach, we are seeing improvement in sentiment.

Also, we are at the last stage of Corporate India's balance sheet clean-up, which will set the base for the next upcycle in the economy. The combination of these factors will lead to a macro improvement, which will feed into micros in maybe a couple of quarters.

Yes, one needs to see the risk appetite in the economy improve, but that will happen with time. Some of the challenges we should be cognisant of are the limited fiscal space of the government to revive the economy, real estate sector revival, private sector leverage, risk aversion and the like.

Timing the market is difficult and there could be volatility, but over the next couple of quarters, one will see a gradual improvement in the economy, which will set the base for equity markets performance, especially the mid-cap space.

Markets are increasingly seeing a trend of polarization where a few stocks have done well, especially largecaps. Coming to midcaps, valuations are still at a premium compared to largecaps. However, the key lies in estimating the future earnings growth.

We believe that growth will pick up from a low and favourable base, given the aforesaid measures. There could be a lag of 2-3 quarters to reflect in earnings growth, which will be the primary driver of stock returns.  And because this part of the market is relatively illiquid, one cannot wait and time the market to perfection.

A better strategy is to get in now or invest systematically over the next 2-3 months.  Overall, I expect 2020 to be a good year for midcap stocks.

Aditya Khemani is a Fund Manager, Motilal Oswal Asset Management Company. Views are personal.