The Mid Cap temptations...

TIME TO LOOK AT EQUITY? The budget has come and gone. It did not surprise anyone either way. On the positive side the budget has done enough to ensure that India is not downgraded by credit rating agencies in the near term. The fiscal deficit planned is a sign of fiscal consolidation and would have pleased the global investing communities. So it is back to basics. Investment should always be based on what we expect the investments to return and not on the basis of a budget action, unless it creates new breakthroughs which results in a paradigm shift for a sector or industry. The one significant impact of the budget is the change in the taxation on dividend distribution tax rates on mutual funds, which makes FMPs and Fixed Income investing under the ‘dividend’ option very unattractive. This effectively makes it more attractive to go in to ‘growth’ option of mutual funds rather than dividend option since the effective tax rate there would be lower. The move has been taken with a view to block the short term investments in liquid funds and FMPs through the dividend option with a view to reducing taxes. All of these make a good case for choosing equities as the asset class to create wealth and also protect wealth against inflation. Given the global economic weakness, a return to the days of high growth seems very distant. And virtually every stock market seems to have done extremely well in 2012, leaving little headroom for 2013. Our stock markets hit their past peak in 2008 when they traded at over twenty four times earnings. In relation to that, the index numbers are near that peak, but with valuations closer to seventeen times. This obviously is a result of some earnings growth. However, in four years, the earnings seem to have grown very modestly. Clearly, 2007-08 was a great year for corporate profits. The other point to note is that our markets are broken markets. Now they are predominantly driven by institutional investors, with the foreign ones dominating. Clearly, the smaller or the retail investor has either lost interest in the markets. As a result, we see a clear divide in the markets between large, medium and small companies. The institutional investors focus more on the large (let us say around 200 companies) and sometimes take a bite here and there from the medium (a universe of maybe another 200 companies). Outside of these 400 odd companies, the market is like an orphan. Promoters, speculators, operators and a few stray investors drive these stocks. Thus, our markets can see divergence that the index does not explain or disclose. We could have a rising index with mid cap stocks falling or vice versa. The recent couple of weeks have seen the mid cap stocks taking big hits. Clearly, the entire market (except for around fifty shares or so) is very illiquid. Small volumes are sufficient to drive prices either way. Also, the ‘impact’ costs of trading in these shares are very high. The difference between the prices one buys and the prices quoted on the screen vary when one actually buys or sells even small quantities. However, the silver lining for the investor is that times like these offer opportunities. In a general price correction, some would be with reason (failed expectations, doubts about promoters or some such factors) and some simply for the reason that there is not enough awareness. Also, when large investors want to play safe, the first exit often happens in mid cap stocks. At times like these, buying opportunities emerge. I am not advocating that one rushes in and buys every stock that has fallen. The important thing is to understand the business of the company and also some idea about the management. If both are satisfactory, there is an opportunity. One big caution though. Do not rush in to put all your money in the small cap or mid caps. Maybe twenty to thirty percent of one’s total exposure to equities could be in this bucket. Risks of further price correction, mistake in one’s judgement about a company cannot be ruled out. There are no guarantees. The only case for investing in these stocks is that some of these small and medium companies will go on to become large companies. Maybe just ten percent would succeed. So, there is a ninety percent chance that some of the small and medium companies would not make the grade. It is important that if one wishes to invest directly in to equities, a lot of time and effort is needed. Simply going by informal word of mouth recommendations is chancy. Take your time, make a list and buy gradually. And do not put everything in to one. Visualise the company’s future five or ten years down the road and see if their business can exist and grow. Understand trends. Do not buy if you cannot understand the business or cannot devote regular time. R. Balakrishnan