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S. Vaidya Nathan

WHERE is the smart money headed? To mid-cap stocks, cutting almost across sectors, it would seem. In April and May, these stocks have gained about 21 per cent. Lakshmi Auto Components, MICO, Sundaram Clayton, Sundaram Brake Linings, Sundram Fasteners, Munjal Showa, Andhra Bank, Phillips Carbon, Raymond and Blue Dart are among the big gainers.

This rally in mid-cap stocks is different from the earlier ones. This is perhaps the first time the market fancy is solely on such stocks.

In 1999 these stocks went up, but along with frontline economically sensitive stocks. In 2002, the rally was alongside the firm trends in information technology stocks in the earlier part of the year and PSU stocks for much of the year. The PSU stocks were dancing to the disinvestment theme, then.

No doubt, the valuation of quite a few mid-cap stocks does look attractive. But the flow of funds almost exclusively into these stocks could be a `big-ticket' risk, increasing the downside. When profit-booking starts, this problem may crop up given that, historically, such stocks have very low liquidity. To track these stocks, one had best steer clear of the indices.

Missing the bus: Keen on the market, investors generally tend to watch the Nifty and/or the Sensex; other indices generally have academic value only. But such an approach can distort the view of what is happening on the street. Investors would be completely missing out on an important theme now driving stock prices.

The broad-based rally covers stocks ranging from Sundram Fasteners to Omax Auto. In the banking sector, the widely divergent Corporation Bank and Centurion Bank are at the forefront.

Cut across sectors and one sees a repeat of stocks of varying hues (barring large-cap stocks) buoyed in this rally that has left the Nifty and Sensex stocks cold.

Joining the party: The Infographic lists stocks that have gained sharply in this phase and indicates trends in traded volumes. Three key factors need to be looked at closely in assessing this trend and making a call on the direction ahead:

Operator driven: It is possible that the rally was driven by operators in tandem with select institutional investors. The situation is somewhat different, in one respect, from the ramp-up seen in the likes of Himachal Futuristic, Global Tele-Systems, Zee Telefilms, KPIT, SSI and Shyam Telecom in 1999-2000. Some media/telecom/IT companies witnessed price ramping despite a high degree of uncertainty and volatility on earnings growth.

In contrast, most stocks from the auto, pharma and banking sectors that are on an uptrend now have a track record of steady growth.

But there are also stocks where the earnings quality is of a doubtful nature. This, to some extent, is inevitable in such rallies as quality options run out within a theme.

As some of higher priced stocks in the mid-cap category may have been missed by investors, the action has also shifted to low-priced stocks.

Quite a few of the latter may not quite fall in the same league in terms of earnings and management quality. But in a bull phase, these aspects tend to be given a quiet burial. This can, however, add to the fairlyhigh element of risk inherent in such stocks.

There is as yet no evidence to suggest that there is a lotof retail interest in the ongoing rally. Any major operator-driven price action, even in large-cap stocks, carries a high element of risk for other investors.

And the risk gets magnified if investors start entering such stocks long after the party has started. This may well be the case in quite a few banking stocks now.

As for the auto sector, the good story in cars has to continue. A similar trend is needed in other segments of the automobile market too. Else there is the possibility of suffering losses due to a belated entry, even into most auto ancillary stocks.

Running out of options: The attention bestowed on mid-cap stocks comes at a time when the traditional sectors/stocks that have dominated the portfolio of institutional investors have run out of steam. Banking is a new theme that emerged over the last year. But it is by no means as dominant as FMCG, pharma and IT were.

Fast moving consumer goods (FMCG), pharmaceutical and information technology sectors have been shunned partially or completely by quite a few funds. These three sectors have been the bulwark for most institutional portfolios for almost six years. Concerns over earnings growth and quality have forced funds to move away from FMCG and IT.

Infosys, Satyam Computer and Hindustan Lever, among others, have thus come under pressure. A traditionally IT-laden fund such as Alliance Equity now has just 17 per cent of its assets in stocks from this sector. This is equally true for pharma sector exposures by a few other funds.

For pharma stocks, the earnings outlook is not as unimpressive as in FMCG and IT. But concerns over the likelihood of success in court proceedings involving battles with MNC companies over going-off-patent drugs have imparted a high degree of volatility.

This is especially true for the three Indian giants — Dr Reddy's, Ranbaxy and Cipla. This is also evident from the gradual shift to select pharma MNCs such as GlaxoSmithKline and Aventis Pharma. These had been given the short shrift over the last three years as Indian pharma companies took the centrestage, delivering big-ticket returns if entry and exit were timed right.

There is one other factor at play as well. The universe of liquid and large-cap stocks that could deliver returns from the economically sensitive sectors, such as auto and commodity-based industries, is small.

Liquidity effect: Mid-cap stocks, barring the likes of Moser Baer, Sun Pharma, Bharat Forge and Aurobindo Pharma, typically have low liquidity levels. For instance, trading volumes in Madras Cements generally range between 1 and 1,900 shares (face value of each share is Rs 100). It is on such thin volumes that the stock has risen 18 per cent in the last month.

This is also a problem in the stocks of Sundaram Clayton, MICO, Sundram Fasteners, Munjal Showa, Goodlass Nerolac, Blue Dart, Heritage Foods and Indian Rayon, among others.

There are unusual spikes on certain trading days. These would be points of entry for institutional investors. In most such stocks, even a small buy order for about 1,000 shares may be enough to move the price 5-15 per cent.

This is also a reason why selling in these stocks tends to get phased out to avoid sharp declines. But buying tends to happen at one lot as a phased-out buying plan may well lead to front-running (where operators buy ahead with the intent to sell to institutional investors).

This adds to the costs of the buyer. In contrast, the effect on the price of a large order on one day may turn out to be less expensive than the costs imposed by front-running. The latter tends to be stiff even in stocks such as HDFC, Infosys and Hindustan Lever, among others.

In mid-cap stocks, the effect would only be more exaggerated. So if you are contemplating buying into mid-cap stocks, it may be better to avoid any action on days when the trading volumes are higher than normal. This could help avoid buying at sharp spikes. Cut to the other side of liquidity — funds flow. If this is concentrated on mid-cap stocks, the ramp-up in prices can be compressed in a very short time frame.

This has been the case so far in April and May. If the information flow turns negative or profit-booking gets underway, prices will move down in a jiffy.

For instance, the Mastek stock tanked up, losing about 49 per cent in one day in April 2003 as the credibility of its earnings guidance came under a cloud. Any potential downside in banking or auto ancillary stocks may not be as sharp or as compressed in a day or two.

But in the past, such stocks as Sundram Fasteners, Blue Dart and MICO have shed 40-50 per cent in a phased manner over two-three months.

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