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Why Have Mid-caps Under Performed in 2018 & What is the Outlook in 2019 In the first 7 months of FY19 industrial growth stood at ~5.7per cent which has literally come to a standstill by the end of FY19

By Jyoti Roy

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Mid & small cap stocks witnessed sharp correction in 2018 after nearly 3 years of consistent outperformance behind them. Post the 2014 elections mid & small caps also benefited from a surge in liquidity as money started chasing growth. While the Midcap index under-performed the Nifty, it still doesn't capture the true extent of the damage in the mid cap space as most individual stocks in the mid cap space were down by over 40per cent.

Factors That Led to Mid-cap Underperformance in 2018

The year 2018 was a clear reversal of an earlier pattern of mid-caps outperforming. That is why the reasons for the fall become a lot more critical.

One of the primary reasons for the sharp fall in mid-caps in 2018 was overvaluation and over ownership in the space. During the peak of the currency crisis in 2013 mid & small caps were trading at a 10-20per cent discount to large caps which also made them very attractive given higher earnings growth as compared to large caps. However by the end of the rally in Jan'18 mid-caps were trading at a 20per cent premium to large caps despite deteriorating growth prospects.

The stock exchanges and SEBI also moved in to curb speculation in mid cap stocks. The imposition of additional special margins (ASM) on some stocks made speculation / intraday trading a very expensive proposition in these stocks. Most traders opted to exit their positions in these mid cap stocks as trading was no longer viable.

An often underrated reason for the mid cap underperformance was the mutual fund reclassification imposed by SEBI. Many diversified funds had to cut down on their holdings of mid cap stocks to adhere to the new SEBI standards.

Deteriorating macros also played a role in the mid cap underperformance. Mid caps had down well when oil prices were low and the rupee was stable. That was the case between 2016 and 2017. During 2018, Brent Crude touched a high of $85/bbl while the rupee went as low as 74.6/USD which had created a risk off environment.

Introduction of Long term capital gains tax could have also played a role. When LTCG was introduced in the budget on February 01st 2018, there was a window given till March 31st 2018 wherein investors could sell their shares without attracting long term capital gains tax. Considering that mid-caps had rallied for the last 3 years, they were the soft targets for investors to book out of.

Midcaps were already under pressure and had corrected significantly from their peak by Sep'18 when the IL&FS crisis hit the markets. The Nifty cracked sharply from levels of above 11,250 to 10,000 in a matter of few weeks. Mid & small caps stocks which were already under pressure capitulated with NBFC stocks bearing the brunt in the last leg of the fall with individual NBFC stocks cracking by 40-70per cent in a few days.

How Will Mid-caps Shape up in 2019?

The economy had ground to a standstill in the aftermath of the IL&FS crisis and the uncertainty in the run up to the general elections as indicated by high frequency indicators like the IIP and auto sales numbers. In the first 7 months of FY19 industrial growth stood at ~5.7per cent which has literally come to a standstill by the end of FY19.

However we believe that the results of the general elections on the 23rd of May will go a long way in boosting investors' confidence given that there is clarity on the policy part. With the incumbent Government coming back to power with a clear majority, reform process is expected to accelerate. Post the election results we expect sentiments to improve somewhat and some of the animal spirit to come back which itself would lend some amount of impetus to the economy.

One of the biggest unfinished agendas of the previous Government was the GST which is still a work in progress. We expect the Government would now focus on simplifying GST and broadening the tax base which will improve tax collections and ease the market's concerns on fiscal slippage in FY20. The Government sticking to its fiscal deficit target for FY20 (without any major expenditure cut) will ensure that there is no crowding out of private investments thus allowing for transmission of rate cuts.

Real interest rates in India are still very high at ~3per cent as compared to the RBI's target range of 1-1.25per cent. We expect at least another 50-75bps rate cuts by the RBI over the next 6-9 months which should bring down the cost of funds for businesses.

The economy is still reeling in the aftermath of the IL&FS crisis with some of the weaker NBFC's facing solvency issues. We expect the Government and the RBI to address the credit crunch on a war footing which would go a long way in bringing back confidence in the markets, ensure smooth flow of credit and allow transmission of rate cuts.

Mid-caps are now trading at a 10per cent discount to large caps just like in 2013 when India was staring at a twin balance sheet problem. However unlike 2013, macros are in much better conditions with inflation, fiscal deficit and CAD well under control. We believe that this is probably the best time to buy into quality mid & small cap stocks given cheap valuations and likely economy recovery in FY20.

However we believe that investors should be careful of avoiding companies with dubious corporate governance history as markets are unlikely to reward them anytime soon. The events of 2018 are still fresh in everybody's mind and investors are unlikely to forget it very soon.

Jyoti Roy

Equity Strategist (DVP) - Angel Broking Ltd

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