We recently wrote on how to pick a mid-cap fund. Which brings us to the question of whether or not this category has the potential to outperform. While attempting to estimate the odds of future outcome, reviewing base rate probabilities is often a good way to start.
Harshad Patwardhan, the CIO of Equity of Edelweiss Asset Management, does just that. He looked at the performance of the mid-cap index (NSE Midcap 100) vis-à-vis the large-cap index (NSE Nifty 50). The time period was the past 20 calendar years (CY) that ended as on December 2020.
The past.
Historically, midcaps have often outperformed large caps. On a CY basis, 60% of times (12 years), the mid-cap index outperformed the large-cap index.
Over the two decades, the mid-cap index delivered 15.6% CAGR versus 12.8% for large cap index. On a 3-year and 5-year rolling returns basis (minimum recommended investment horizon), the mid-cap index outperformed the large-cap index 65% and 77% of the time, respectively.
In absolute terms, 70% of times (14 years) the mid-cap index delivered positive returns. Its best performance was in 2003 at 138% while the worst was in 2008 at -59%.
The mid-cap index delivered over 30% returns 7 times, while it delivered worse than 30% negative returns twice.
Another interesting and important lesson from history is that returns tend to be front ended in rising markets.
The present.
More recently, mid caps have lagged. Over the past 3 and 5 years, ended December 2020, the large-cap index delivered CAGR returns of 9.9% and 12% respectively, compared to -0.5% and 9.2% of the mid-cap index.
Most of it was due to severe underperformance of mid caps in 2018 and 2019. The mid-cap index lagged the large-cap index by 19 and 16 percentage points respectively, its worst underperformance on record. This was a period of a narrow rally in the market where only a handful of stocks drove the indices higher.
This is important.
The analysis involved comparing large-cap and mid-cap indices. However, actively managed funds have generated better alpha in the mid-cap category when compared to the large-cap category.
The worst is behind us.
Even before the pandemic, Indian economic growth was already decelerating for last several years. This was partly driven by India specific disruptions such as demonetization, implementation of GST and the NBFC crisis. Just when the Indian economy had started showing signs of green shoots from 4Q2019, Covid-19 struck. Lockdowns implemented to control the spread of infections resulted in a record 24% contraction in the economy in 2Q2020. However, it also marked the bottoming out of economic activity which has since smartly picked up.
We expect economic growth to be broad based on the way up.
We expect economic activity to accelerate and corporate EPS growth trajectory to be significantly higher over the next few years compared to the lackluster low single digit levels over the past few years. More importantly, we expect recovery to be inclusive.
Apart from the usual downstream economic linkages, policy thrust in many areas will benefit listed businesses in the mid-cap segment. The government has demonstrated an unrelenting focus on reviving and sustaining growth over the medium term. Its push towards agricultural reforms will benefit food processing. It is easing of labour codes and efforts towards formalization would enable many smaller businesses to scale up and be competitive. Its push towards boosting manufacturing within India and sprucing up infrastructure will also make the economic growth more broad-based. Announcement of PLI scheme for mobiles and enhancement of its scope to include several more sectors will benefit a host of small sized businesses. Infrastructure push in areas such as road, railways, ports, urban infrastructure, and housing is already leading to benefits accruing to downstream small sized businesses.
We also expect monetary policy to stay benign over the medium term, creating a conducive environment for inclusive growth.
Mid caps likely to reverse the recent underperformance.
An economic recovery will help a wide range of businesses, many of which belong to the mid-cap category. Foreign flows continue to be robust and data shows that they also invest in mid caps -contrary to the widespread belief that they don’t. Domestic flows could eventually turn with more evidence of a growth pick up.
We therefore expect mid caps to start outperforming large caps over the medium term. Even in a turbulent year like 2020, the mid-cap index outperformed the large-cap index by 7 percentage points.
A word of caution.
Never forget that mid caps will likely be more volatile and that corrections are part of the game. Investors should assess their risk appetite before investing in this category.
The views expressed are those of Harshad Patwardhan, CIO – Equity, Edelweiss Asset Management Limited.
