This article has been contributed by Amay Hattangadi and Swanand Kelkar of Morgan Stanley Investment Management.
In his book
Breakout Nations, Ruchir Sharma, head of Emerging Markets at Morgan Stanley Investment Management, writes that failure to sustain growth is the general rule among emerging markets.
Only two emerging markets, he writes, have maintained an annualised growth rate of 5% rate over five decades. Sustainability of growth is as much an issue for companies as it is for economies.
Just as few emerging markets have been able to grow sustainably and become high income countries, similarly few companies have been able to endure economic cycles and market fads to deliver consistent performance, measured both in terms of earnings growth and stock price returns.
The holy grail of investing is to discover a mid-cap stock early in the game, sit back and watch it ‘grow’ into a large-cap. Using an analogy from the plant world, just as every tree cannot grow to be as large as the giant sequoias, so too, not all mid-caps will follow a linear path of sustainable growth to become large-caps.
We look at trends of the last few years to observe that a high rate of attrition ensures that there are only a select few ‘giant sequoias’ in the market.
While there is no strict definition of market capitalisation for mid-cap or large-cap stocks, we have used thresholds of $5 billion plus for large caps and a range of $2-5 billion for mid caps. Based on these cut-offs, there are 64 large-cap stocks and 71 mid-cap stocks today in India.
A look at past trends indicates, not surprisingly, that the stock count of large-cap stocks rises significantly during a strong bull market rally, as one or more sectors catch the fancy of investors and witness a significant valuation re-rating.
Click here to see how the mid-caps of 2007 are faring in 2015.
Number of large caps
The number of large-cap stocks in India rose from a paltry count of five in 2002 to 68 stocks in 2007. Interestingly, after falling to as low as 26 in the aftermath of the global financial crisis of 2008, the number is back to 64.
More interestingly, of the 68 large cap stocks in 2007, only 36 continue to be on the list today, implying quite a significant churn in the list.
This high level of attrition indicates that while it is not only difficult to enter the elite group of large-cap companies, it is almost as difficult to remain in the group. Many stocks benefit from the adage ‘a rising tide lifts all boats’ if they are in the right sector at the right time - as has been the case with the technology sector from 1997-2000, or infrastructure related sectors from 2002-2007.
Once the tide recedes, few among the group are able to sustain the earnings trajectory or continue to maintain high stock price returns.
Many mid-cap funds are launched with the marketing pitch that smaller sized companies will be able to compound their market caps faster. However, a look at the mid-cap indices suggests that over the last 5 and 10 years the mid-cap indices in India have barely managed to outperform the frontline large-cap indices.
Click here to see tthe performance of large-cap and mid-cap indices over varying time periods.
This raises the question whether mid-cap investing in India is more about getting the sector themes right rather than buying stocks with a view that they will secularly graduate to becoming large-caps. Data quoted earlier does prove that linear extrapolation of stocks from mid-caps to large-caps is more an exception rather than a rule.
If an investor is able to make early bets in themes that catch the fancy of the markets, and rotate out of them into newer themes before the old one fades out, one can make outsized returns. But this involves superior insight and great timing. And of course if one is able to pick the secular winners from this group, the rewards are spectacular. But more often than not investors end up chasing mid-caps that are already ‘hot’ where the odds that future returns will continue to sustain for the medium to long term, are low.
To conclude, investors should recognise that attrition is often the rule rather than the exception, when they seek to discover the giant sequoias in the stock market.
