Tridip Pathak, chief investment officer, Cholamandalam Mutual Fund, firmly believes in Darwin's theory of evolution which is built on the process on natural selection: as random genetic mutations occur within an organism's genetic code, the beneficial mutations are preserved because they aid survival.
These beneficial mutations are passed on to the next generation, and over time, they accumulate and the result is an entirely different organism (not just a variation of the original, but an entirely different creature).
Applied to stock markets, the theory explains the status of mid-cap stocks today. According to Pathak, the stage at which mid-caps are now is part of the natural evolution of the market as also the economy.
How? The economy and markets have undergone several mutations over the past decade.
Capital market systems and the regulatory environment have seen a lot of changes over the past few years. And, with the economic liberalisation policies of the 1990s, competitive pressures have increased and tariff protection has come down.
The beneficial changes of this are manifested in the form of a more efficient system, which reduced the risk of systemic failure, and a far more stable macro economic environment and resilient business models.
The survivors in the mid-cap segment are set to evolve further into large-caps in the years to come as the process of 'natural selection' continues.
With continuing reforms and high economic growth, a variety of opportunities has opened up for Indian companies.
At this juncture, the risk associated with these companies is significantly lower than, say, a decade ago. "There are far more credible mid-cap stories today than ever before," Pathak affirms.
There are many other reasons to buy mid-caps. "Many mid-cap stocks have the potential to become large-cap stocks tomorrow and thus create long-term wealth," says Pathak.
Of the top 50 stocks in terms of market cap, as many as 20 were mid-cap stocks seven-eight years ago as per a study done by Chola Mutual.
"This is a natural process of evolution of companies in a dynamic and fast-growing economy like ours," Pathak reiterates.
Also, history has shown that mid-cap companies have a higher return profile than large-cap companies in general. Being neither small nor large, mid-cap firms have attractive risk/return profiles.
Again, the mid-cap segment offers a variety of stocks. "There is a large and diverse group of companies to choose from among the mid-cap universe of stocks.
This enables us to create a well-diversified portfolio," Pathak says. Unlike large-caps, many of these companies are under-researched and provide opportunities for being identified as undervalued companies.
One problem with mid-caps has been the lack of liquidity. But, Pathak says, there is a natural window to create liquidity. Because ownership in large-caps is peaking.
The FII stake in the top 50 stocks in terms of market cap has already crossed 20 per cent, leaving little room for them to buy large-caps.
As a result of this, more and more of their flows are going towards mid-cap stocks. Currently, 20 per cent of the incremental foreign institutional flows come into mid-caps compared to about 5 per cent about three years ago.
While Pathak's approach is bottom up, he has constructed the portfolio of his recently launched Chola Mid-cap Fund based on four major themes.
Proxies: Companies, which are proxies for large-cap. The idea here is to capitalise on the discount that certain mid-cap stocks trade at where the quality of business is more or less the same.
For instance, take the case of cement. Stocks like Birla Corp and Shree Cement trade at a substantial discount to large-cap stocks like ACC or Gujarat Ambuja.
Based on current prices, ACC's shares command an enterprise value of $95 per tonne while Gujarat Ambuja trades at $110 per tonne. On the contrary, Birla Corp trades at $55 per tonne while Shree Cement trades at $70 per tonne.
With the cement business set to improve, these smaller companies are likely to benefit at least as much as the larger players. In fact, some smaller players with higher leverage may post better growth in bottomlines due to their higher sensitivity to prices.
Ditto for petrochem companies like Finolex Industries and Polyplex. While the former produces PVC pipes, the latter manufactures PET films. Both are goods plays on the petrochemical cycle.
They are reasonably good proxies for companies like Reliance Industries and IPCL. Since the petrochemical cycle is on an upswing with a favourable demand supply situation, these stocks should do well at the bourses.
Similarly, Chennai Petroleum, a pure refining company, is a good bet in the oil sector, especially at a time when oil marketing companies are seeing their marketing margins being squeezed due to their inability to pass on hikes in crude oil prices to end users.
Strong refining margins coupled with reasonable volume growth makes the stock a good pick. Chennai Petroleum also offers good dividend yield at current levels. Other stocks that come under this category are Ipca Laboratories, Ashok Leyland and Aventis.
All the three of them trade at a discount to their large-cap peers. Ipca trades at a discount to large-cap domestic pharma companies while Aventis is one of the cheapest MNC pharma stocks available at the bourses.
Commercial vehicle player Ashok Leyland also is available cheap compared to competitor and large-cap peer Tata Motors.
Leaders: The second category is stocks, which are large in their own right. These are stocks, which are market leaders in their respective business segments by virtue of the fact that there are no large-cap stocks operating in that segment.
For instance, express company Blue Dart. It has a leading market-share of 30 per cent in the domestic courier business and runs its own aircraft.
Similarly, sugar company Bajaj Hindusthan is betting on the expansion of its crushing capacity and is set to be a large player. It is already the second-largest sugar producer in the country.
Similarly, companies like Gammon India, Ballarpur Industries and Jain Irrigation figure among the top two-three players in their respective fields.
Likewise, ink company Micro Inks is the largest player in its segment with a 35 per cent marketshare in the domestic market. The company would also qualify under the third theme.
Global: The third segment has been a hot selling story among fund managers in the past few months - globally competitive companies. These are firms which operate in established businesses and are taking advantage of their business strengths.
Micro Inks, for instance, derives about 65 per cent of its revenues from exports and has a significant presence in America. It is the 11th-largest ink player in the US markets.
Again, auto ancillary players Sona Koyo and Mico have tremendous potential to tap the exports market. In fact, Mico will see significant upside, thanks to outsourcing by its parent.
Cummins will also benefit from outsourcing by the parent. Voltas is tapping the export market aggressively.
Another big global opportunity that the market is gung-ho about is textiles.
Pathak is betting on Welspun to capture upsides following quota liberalisation in the US after 2005.
Niche technology firm Hexaware Technologies and BPO player (business process outsourcing) MphasiS BFL also qualify under this criteria. Though MphasiS is primarily an IT services company, it is one of the few listed candidates to derive a substantial portion of its revenues from BPO operations.
Sunrise Sectors: These would include companies, which operate in businesses, which are relatively new and are likely to see phenomenal growth going forward.
Sectors like retailing and contract manufacturing are Pathak's key bets. These are businesses, which are at a nascent stage and are still evolving.
Stocks which fall in this category are Nicholas Piramal, which has decided to be in the contract-manufacturing space, Vimta Labs, which is a pharma export story, and Pantaloon Retail, which is one of the largest retain chains in the country.
Pathak says some of the stocks mentioned above may fall under more than one category.
For instance, companies like Bajaj Hindustan qualify as proxies as well as leaders. Similarly, Hexaware and MphasiS are niche players and at the same time also qualify as globally competitive.