May 2018: Mid Cap correction takes a bite off the market

The current calendar year, CY2018, has been one of muted returns for the Nifty – it is up 2.0% year-to-date. However this somewhat stable picture hides an important detail – the broader market has had a decent size correction. The BSE Midcap Index and the BSE Small Cap Index are down -10.1% and -10.3%, respectively. Most of the diversified equity mutual funds are trailing the Nifty – perhaps because of their exposure to mid-caps and small caps.

For all companies that have a market cap of Rs 500 cr and above, the median drawdown from their respective highs in stock price in the last 12 months, as on end May is 25.1%. Almost ~39% of our sample of 1037 companies are down more than 30% over the last 12 months and 71 companies have halved or more in this period. So the mid cap and small cap correction has been quite steep. We have spoken about the valuations of the mid-caps and small caps in prior letters. The larger cap companies have been relatively steadier and have offered some capital protection in this correction.

One of the reasons for the muted sentiment on India is that oil prices have been climbing quite rapidly and Brent crude oil futures are up more than 50% over the last 12 months. This has obvious implications on India’s current account deficit – the effect of which is visible on the rupee as well. Moreover, if prices continue to rise, the higher prices may prompt the government to consider reducing the excise duty on oil to mitigate the impact on the common man – this can potentially have an impact on the fiscal deficit of the government. Oil prices also feed into inflation which can hurt consumer spending. Interest rates have risen recently, which will impact consumption.

Also the results of the PSU banks in Q4 have been shocking in some instances and are prompted by the RBI’s new strict guidelines for NPA recognition. Many of the PSU banks are unable to lend – this continues to be a drag on the economy.

The valuation of many mid cap and small cap companies have been out of sync with their trading history – and therein lurk some mine fields for investors. In many cases, mid cap companies were trading at valuations that were at a premium to the large cap companies in their own sector – this is a bit unusual from the historical perspective. We are careful to use the past tense with respect to mid-caps because this was the situation a few months back – valuations have changed, price wise, in the last few months. The large cap companies though also a bit stretched on valuations in some cases, still offer a few opportunities to get invested.

Our portfolios have been more weighted towards the large cap stocks and this has helped us in this period of volatility. The results of most of the portfolio companies declared so far have been reasonably good and there have not been too many disappointments. We are fairly comfortable with our current portfolio – we see a few good opportunities. Though there may be near term head winds for the economy, the Indian consumer is on a strong wicket and the capital goods cycle should gather steam in the coming years. Should the correction persist for some more time, we could get some more opportunities to get invested.