Why should you invest in mid-cap stocks?

Love Them or hate them, but you can't ignore them. There is something about mid-cap stocks that evokes similar sentiments in seasoned, as well as novice investors. The mid-cap space in the stock market is often overlooked by big investors and foreign institutional investors (FIIs). Investment in such scrips is considered risky, as these tend to be more prone to volatility compared to large-cap scrips.

But whenever the market has tried to almost write off mid-cap stocks, they have bounced back with a renewed zeal. This has happened on several occasions in the past. Nevertheless, the latest mid-cap rally hardly comes as a surprise. This year, the mid-cap indices have already outperformed the broader benchmark indices.

This week, ETIG has attempted to analyse the reasons behind the current rally in mid-cap stocks and also forecast what lies ahead for investors who place their bets on this space.

During the major part of the current calendar year, large-cap investment remained a dominant theme. This was mainly because the domestic stock market saw a major inflow of funds from foreign institutional investors (FIIs), which focus mainly on stocks of those companies which are part of the benchmark indices. So, while large-cap scrips literally had a ball, the mid-cap story remained almost unsung.

However, the situation changed significantly in favour of the mid-caps after the first interest rate cut by the US Federal Reserve in the middle of September. On the face of it, the mid-caps did not directly benefit from the rally that immediately followed the Fed rate cut, during which, the valuations of large-caps soared further and farther. But a dramatic change in events took place soon after.

The gap in valuations of large-caps and mid-caps suddenly appeared unreasonably wider after the September quarter results, as mid-cap companies recorded better growth. "During the second quarter of the current fiscal, CNX Midcap companies reported 29% earnings growth — better than the 24.7% growth of the Nifty companies — which attracted domestic mutual funds, as well as retail investors to the mid-cap space," says Gopal Agrawal, senior fund manager at Mirrae Asset Global Investment Management (India).

At around the same time, FIIs gradually started pulling themselves out of the Indian stock market. "FIIs pumped lesser money in October compared to that in the previous months and were net sellers in November. Thus, large-caps — the favourites of FIIs — lost some steam there, while mid-caps gained ground with renewed interest from local investors," says Mr Agrawal.

During '07, the mid-caps, on an average, earned robust returns for those investors who had put their faith in the mid-cap story. But will the party continue in '08? We posed this question to the experts and the reaction was mixed.