Midcap and value investing are different

Experts tell all on small, mid-cap and large cap stocks and what
patterns to look for.

Stocks are where everybody seems to be putting in money. The returns
could be wildy good or chillingly disappointing. So how do you pick
the winning bets all the time? A little careful homework and expert
guidance will always help. Investment consultant, SP Tulsian and Anand
Tandon of Gryffon Investment Advisory talk to CNBC-TV18 and untangle
some commonly used terms and explain the basics of the stock market
game.
People often think that the line between midcaps, small caps and large
caps are blurred. How do you see midcap stocks?
Tandon: The way I look at mid-caps is actually not so much in terms of
market capitalization as in terms of the fact, that you should be
looking for a stock, which can be a multi-begger over a period of
time. If you were to look at business cycles, there are companies that
typically go through a (particular) stage when you are a start-up.
Then you go through the next kind of growth phase and then you start
to mature.
Now, typically when we are talking about midcaps, what we are looking
for is those companies, which have come out of the initial start-up
kind of phase, and are now at a stage where they can look at
significant growth opportunity. One of the things that I have found is
that, and a lot of people get confused about is that mid-cap has got
nothing to do with value investing. It may appear that you are looking
for small companies and therefore you are looking for companies, which
are so called, deep value. I think those two are completely different
kinds of investment styles.
In value investing, you will look for something, which is say, worth a
rupee and is available at 50 paisa. In mid-cap investing, what you are
really looking for is something worth a rupee, which can grow to Rs 10
over a period of the next 3-4 years.
So you are saying, it's not a conservative style of investing at all.
In fact, it is quite the contrary, it could be quite aggressive?
Tandon: Absolutely. It is an extremely aggressive style of investing,
which requires you to be up to speed in terms of where the business is
growing. Does the company have the ability, the desire and the
capability of actually taking that kind of growth path without
cracking up. Therefore, take attendant risks on that. But it is a
necessarily high growth investment philosophy.
How do you look at midcaps? How do you distinguish between large cap and midcap?
Tulsian: If you take the price barometer or the general yardstick,
which we have, generally we say that 'okay below Rs 100 crore is a
small cap company and say Rs 100-Rs 1,000 crore is a mid-cap company
and above Rs 1,000 crore is large cap company'. That is how the
companies keep graduating - they shift from mid-cap to large cap. One
can say that Infosys was a mid-cap company, maybe 15-years back, they
have graduated to a large cap stock now. So that is the way of
identifying the stock to satisfy the requirements of an investor
because mentally they are not comfortable. Even in this demat arena,
if you tell them to buy any share of Rs 500, they say 'oh this is a
very highly priced share'.
One can understand when the market was not used to being hunted. So it
is very much essential to define the norms of mid-caps and all that.
The second advantage of identifying mid-cap stocks is that, they have
the potential to grow, as Anand has said, maybe they can become
multiple-beggars because generally in large cap stocks, you have the
limitation that they cannot double in a year's time. While we have
seen the stocks, we identify them on those lines that they will grow
by 5-10 times in a year. So that is how they multiply the returns to
the investor.
Another popular question that people ask is, give me a stock which is
less than Rs 100, (because they believe) that's a midcap stock.
Obviously, the sale price could be Rs 50 but it could be a very large
cap stock, so the absolute price of the stock does not make it a
mid-cap?
Tulsian: I think that is what we would normally say. Then, we can call
them mid-price stocks. Take for instance, if sale is ruling at Rs 60,
they have issued shares of Rs 400 crore plus shares, so they have a
market cap of Rs 25,000 crore. Truly, we cannot really call that as a
mid-cap stock. They will necessarily have to fall in the large cap
stock, but they can be called as mid-priced stock instead of calling
them as mid-cap stocks.
A lot of people stay away from mid-caps, saying that we don't
understand them, they are not very well researched and I am better off
taking my bet with Infosys and Reliance, which is well researched and
therefore risks are lower. Is that a fair theory that the risks are
higher in midcaps?
Tandon: It depends on how you define risks. If you are talking about
the fact that mid- caps by their nature, maybe somewhat
under-researched and therefore to some extent also somewhat ill-liquid
- then if your risk is on the question of liquidity, and therefore
(see if you) can get out in a hurry? Certainly, it is not something
that you can do with midcaps. Midcaps is something, where you are
looking to have a multi-beggar, you are not looking for a 20%-30%
growth. In that case, you might be better of buying some of the more
well researched companies. What you are looking for is that you have
to stay with the company for 2-3 years and get 5-10 beggar, that's
your hope. So in that case, liquidity should not be a major criteria
for defining risk. The risk should be defined in terms of business
risk, like, can the company sustain its growth, does it have the
capability etc? Also for example, does it have the management depth?
Can it trace money etc?
There is a huge premium on management quality. Is it more important in
large caps because they don't have a proven track record?
Tulsian: Let me put it in this way, that management quality is
required in all the three categories, whether it is large cap, small
cap or mid-cap. But yes I do agree that in the mid-caps, one has to be
more vigilant about the promoters background and their experience in
that particular field. For instance, take any particular group, if you
take sugar or steel industry, we have so many groups who have
specialization in that particular industry and they don't go wrong
even at the time of recession because they know the tricks of the
trade. So it is important to take a first call on the industry and
then on the promoters.
How do you go about doing this?
Tandon: In my experience, I have seen a lot of managements go from so
called, not-so- shareholder-friendly to being shareholder-friendly
when the time is right. In India, we have got a situation where lot of
the entrepreneurs are actually first generation entrepreneurs. So yes,
when it comes to family investing, there are issues that you have to
worry about because there is a long history to go back to. Also you
have to look out, about how the family is going to split and who is
going to control what?
But when it comes to first generation entrepreneurs, by and large,
those people are the people who want to make things happen, which
means, for example, if they have started 15-years ago, you would be in
a situation, where the License Raj would have prevented you from doing
a lot of things. The inability to access capital would have forced you
to do things, which you may not normally regard as being particularly,
"clean."
Now, as the size increases and as the opportunity to raise capital
becomes easier without having to trifle with the laws etc, what I have
found is that a lot of companies don't really want to do that. So they
actually become clean. So yes, I agree entirely, that management
quality is important, except that it is not a static phenomena.
Managements change with times. There is no doubt that there are people
who are culturally out to fleece you in the market. But I don't think
this stays in the market for long. So if the company has been around
for a while and doing the right things, in terms, of its objectives of
growing. I think you can be a little lenient, in terms of the fact
that the promoter has bought himself a Mercedes before he has given
you a very high dividend.
Are there any checklists, like frequent dilution of capital,
inter-group investments, maybe siphoning of some of the funds of the
company? How can you ascertain all of these things?

Tandon: I think, the fundamental thing is, whether the shareholders'
interest is aligned with the key promoter's interest. For instance,
take the example of MNCs, in most cases that is not true, even though
MNCs at one time were treated as being the best investment
opportunities. For example, take the pharma space, for the last whole
decade, more or less the MNC pharma has under-performed and this is
not because of any unethical practice, just that the interest of the
foreign shareholder is to make sure that you grow the domestic market.
The domestic market is a tight market to grow, but the local companies
are not able to access the overseas market, which the domestic
companies are able to do. So that is, why we had the phenomena, where
Glaxo has not grown or has not grown anywhere close to the same
proportion, as say, Ranbaxy has grown. So the first and most critical
thing is, are you interests aligned with that of the majority
shareholders?
Should you be concerned about investing in MNCs in any space -
mid-cap or large cap?
Tulsian: In the present scenario, yes, because the kind of growth and
the kind of innovative things they bring in here, are not very
fantastic or great. Even, if you see the Indian pharma companies, they
are practically floated by all professional people. That may not be
the case earlier. Suppose if any industrial house or any entrepreneur
has got the license, maybe for automobiles or for steel or for
petrochemical, he is not necessarily an engineer in that field, but
that scenario is changing now. So obviously, the competence of a
promoter plays a very important role, while this is not working out
very well for the MNCs.
The market also works with strange thumb rules. Look at the valuations
that are subscribed to different stocks, old family run businesses
typically get a lower multiple than new generation companies that are
run by technocrats. Is that a good thumb rule?
Tandon: I think most of the traditional Indian businesses have been in
mostly, commodity sectors. So you have been in steel, you have been in
paper, you have been in a whole host of sectors, which are cyclical,
which are global commodities and as the barriers to entry have fallen,
in terms of easy availability of capital, removal of restrictions on
licenses and lower tariff barriers, these businesses have suffered in
terms of valuations. The new generations entrepreneurs, typically tend
not to have that much capital, therefore they are looking for services
business, and service businesses are less capital intensive and will
perforce enjoy a higher valuation. So I think, it's more of factor of
than the fact that it's old versus new.
What are the top 2-3 valuation criteria that you look for?
Tandon: As I mentioned to you earlier, the question is, when do you
make maximum money out of mid-caps? Therefore, the value is determined
accordingly. I think mid-caps go through an inflection point. Now that
inflection point is usually because there is something new. That
something new could be a new business, new product, new service, new
owner, new management or new government policy. At those points, is
where you will find the maximum expansion in terms of valuation.
So, if you are still looking backward and saying hey textile is not
looking that great because it's traditionally traded at 5 PE, because
capital output ratio is 1 and suddenly we have a situation where you
are moving into a phase where quotas go away and simultaneously the
government gives you money at 2%-3%, what has happened is that the
same business is now decommoditised for a while because (1) your
market size has increased tremendously and (2) your capital output
ratio remains 1 but the cost of capital has fallen a lot and therefore
equity return can go up significantly over the next few years. So
suddenly, valuation changes from a median five to median ten, without
anything much happening with the company, per se.
Now, if you were to look back a year and say that look, today textile
looks overpriced, I would disagree because of these factors. My view
is, the valuations are likely to stay at a higher-level. So I would
look for inflection points that are changing, and the second is, what
is the change and what is driving the change. For example, it's a
commodity and it's just a price of the commodity. There is not much
that the company has done and therefore if there is expansion of
valuation, I would be a little more suspect on that. But if for
example, the valuation expansion has happened, because for eg.
Mahindra has launched a new car and that car is doing exceedingly
well, I think it's likely to stay for much longer.
So you differ with Anand Tandon, by saying that you should not justify
the price by saying there are great opportunities because you may go
wrong there?
Tulsian: Yes you may go wrong there.
Can you give us some example of where people may have paid too high a price?
Tulsian: We have the IT sector before us because in 2000, the Y2K
(scare) and all that had come. Practically, if you see the second rung
companies or the mid-cap IT companies, the market in fact, in some of
the cases, has been giving higher P/E multiple to those companies
rather than Infosys.
So, those cases have been in front of us, where the price from Rs
1,000 is now ruling at Rs 10. What has been the change or the failure
of those companies? So this is the classic case even today. There are
4-5 companies, which are ruling even higher that Infosys' P/E
multiple. So we say, that they have the potential in the coming days,
which we are not really able to assess.
Do people get carried away using the logic that this industry is on
the verge of inflection point, therefore any price is fine?
Tandon: I don't know, whether I didn't quite convey what I was saying.
I was saying historic earnings or historic valuations for any industry
versus valuations post- inflection point, is not comparable. I am not
saying that a better company or better managed company should not
trade at a higher valuation, because theoretically a better managed
company will have greater earning stability and that's one of the key
factors that we are looking for.
So if you are able to forecast stable earnings and growing earnings in
the same ratio for a smaller company, you would obviously think that
the smaller company should be valued a little lower, simply because of
its being smaller. It will have disadvantages of size, which means
that it will be able to access capital less, it will be able to get
manpower less readily and so on.
But what I was trying to point out, is that you cannot take an
historical benchmark for an industry. The key point for investing in
mid-caps is, if you can find the inflection point, at that point of
time, don't be too finicky about the valuation. One of the good
examples is the retail sector, where the numbers are yet to happen but
the valuations have gone through the roof.