HSBC Research, Looking at mid-cap themes for 2014

 Mid-caps have underperformed largecaps in the last 6 years. With no easing
in sight we remain selective on them
 Three themes to play in 2014:
insulation from leverage-related stress;
rising utilisation; and strong earnings
momentum with reasonable valuations
 Analysts’ preferred plays: PTCIN, IPCA,
TRP, PEPL, BHFC, LICHF and ILFT

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Severe underperformance of mid-caps: Since the
beginning of 2008, mid-cap stocks have underperformed
large-cap stocks by c.40% as investors preferred large-cap
liquid stocks over relatively risky mid-cap stocks.
Selective on mid-caps on uncertain economic
environment: Although mid-cap stocks are trading at
record-wide valuation discounts to large-caps, high policy
rates makes us selective on this universe. Mid caps generally
perform in scenarios of surplus liquidity (when money
moves beyond opportunities in large caps), easy monetary
conditions and in cases of secular economic recovery. Our
economist is expecting the RBI to raise the policy rate in
2014 given lingering inflation pressures.
Three key mid-cap themes to play in 2014: In our view,
investors who choose to look at mid caps in 2014 should
adopt a selective approach. In this note we highlight three
themes in 2014:
 Stocks that are relatively insulated from leverage-related
stress. Our equity analysts highlight two pharmaceutical
companies: IPCA Lab and Torrent Pharma
 Stocks that are seeing an uptick in utilisation. Our equity
analysts highlight Bharat Forge and IL&FS Transport
 Stock that offer strong earnings momentum with
reasonable valuations. Our equity analysts highlight LIC
Housing Finance, Power Trading Corp and Prestige Estates

Six years of underperformance
Over the past six years, mid-cap companies have
significantly lagged large-caps, with the BSE
Mid-Cap index underperforming the Sensex
Index, whose constituents are the most actively
traded large-cap stocks, by 4,000bp.
Chart below clearly shows how investors have
become risk averse since 2008, preferring India’s
larger listed companies to their smaller
counterparts. In our view, this shift in investors’
focus from small to big was driven by concerns
over high leverage and poor corporate governance
among mid-cap companies.
Indeed, while the average debt to equity of the 50
companies in the Nifty Index is currently around
72%, the BSE-500 Index constituent companies,
excluding those that are also in the Nifty, have an
average debt to equity of almost 130%.
Although mid-cap companies in the long term
deliver better returns than large-cap, they typically
tend to underperform during down cycles.
The case for investing in midcap stocks
The mid-cap index has severely underperformed the
large-cap index in the past few years resulting in a
high valuation gap. Currently, the mid-cap index is
trading at a 39% discount to the large-cap index.
Although mid-cap companies offer better returns
in the long term with a slightly higher level of risk
and there is a record wide valuation differential
between mid-caps and large-caps, we expect
large-cap stocks to outperform in the near term.
In our view, 2014 is likely to continue to be
painful for smaller stocks as uncertainty over QE
tapering and the coming domestic elections keep
investors biased towards low beta trade.


Time for a reversal?
Our economist believes the RBI is likely to raise
the policy rate further in 2014, as inflation
pressures remain. Given that leverage rises quite
dramatically from-large-caps to mid-caps, this
hardly makes the case for investing in mid-caps
compelling. On the other hand, foreign institutional
investor (FII) holdings in mid-cap stocks have
fallen consistently over the last six years.
QE tapering by the Fed is also likely to have a
bearing on capital flows into emerging markets
and it is difficult to envisage excessive inflows
into Indian equities in such an environment. In our
view, though their valuation gap with large-caps
has widened, mid-caps lack material fundamental
catalysts to stage a broad-based turnaround.

Three key themes for 2014
In our view, investors who choose to look at midcaps in 2014 should adopt a selective approach
based on the following three key themes:
1. Relative insulation from leverage-related
stress. Given our expectation that policy rates will
remain high in 2014 on the back of sticky
inflation, we would be cautious on most names
with high leverage. In terms of this theme, our
equity analysts highlight two pharmaceutical
companies, IPCA Lab and Torrent Pharma.
 Ipca Lab (IPCA IN, CMP: INR701, OW
and TP: INR805): US growth has become a
reality. Post the USFDA’s approval of SEZ
Indore facility, Ipca expects US sales to rampup significantly with the first few launches
due in 4Q FY14, along with two new
approvals and site transfers for one-two old
products. Ipca’s export formulations have
bounced back strongly, post the recent
slowdown in a few markets due to the
implementation of a new tracking system.
Our analysts expect export formulations to
outgrow domestic formulations sales with a
CAGR of c24% (against 14% for India) over
the FY12-15e.
 Torrent Pharma (TRP IN, CMP: INR469,
OW and TP: INR537): Despite the overall
market slowdown due to new pricing policy
and trade disruptions, Torrent’s India
formulations sales remain strong on the back
of a healthy product mix with c65% its
product portfolio for chronic therapies like
cardiac, CNS and diabetes, (2Q FY14 sales
growth of 14% versus market growth of 3%).
The US contributes c12% of total company
sales, and is one of the fastest growing
markets for Torrent. Despite being a late
entrant in the US market in FY06, Torrent
had a healthy product launch rate of 5-6
products per year and has a decent pipeline
with 24 pending ANDAs. Our analysts expect
the US to remain a strong source of growth
for the company, led by new launches and
increasing market share in existing products.
2. Uptick in utilisation: Our economists expect
the Indian economy to bottom in FY14 and slowly
resume a growth trajectory. While execution
related risks in corporate India remain elevated, a
number of companies have already completed
their capital spending programs over recent years
and are poised to see a recovery in cash flow. In
terms of the utilisation theme, our equity analysts
believe that Bharat Forge (which is benefiting
from a recovery in both the local and overseas
markets) and ILFS are key stocks to play this
theme. ILFS does have a significant degree of
leverage but most of the leverage is structured
around toll roads and annuity incomes.
 Bharat Forge (BHFC IN, CMP: INR320,
OW and TP: INR380): BFL is one of the
largest forging companies in the world and, as
a standalone entity, enjoys cost leadership and
a track record of efficient operations. Our
analysts believe the company has one of the
best management teams in the engineering
space and its focus on managing its human
resources is one of the best in the industry
resulting in higher efficiencies and better cost
management. Further, its ability to source raw
materials from its sister companies also
enables it to manage costs better.
 IL&FS Transportation (ILFT IN, CMP:
INR138, OW and TP: INR172): ILFT is
poised to make seven projects operational in
2014e. Three of these will be among ILFT’s
top four assets; it has 26 road assets in total.
With the launch of these seven projects, our
analysts expect ILFT’s average daily cash
collection to increase threefold to around
INR60m by FY15e. This will likely ease
investors’ main concern about the company
and the sector – namely, potential delays in
cash flow generation – limiting developers’
ability to cut leverage.
3. Strong earnings momentum with reasonable
valuations: On the theme of strong growth at
reasonable valuations, our analysts highlight three
names in the mid-cap space: 1) LIC Housing
which is in the resilient mortgage finance
business, 2) Power Trading Corp, and 3) Prestige
Estates.
 Prestige Estates (PEPL IN, CMP: INR157,
OW(V) and TP: INR190): Prestige
maintains a very high level of corporate
governance/disclosure standards and has been
able to meet its guidance successfully since
listing. Despite some weakness in key
markets like Bangalore, its sales momentum
continues apace driven by strong presales and
a strong brand. The company has a diversified
product mix ranging from mid-market to
premium offerings in the residential segment.
It has also it has nurtured a wide client base
for its commercial projects. The company has
high cash flow visibility based only on the
projects that are currently under development.
 Power Trading Corp (PTCIN IN, CMP:
INR61, OW and TP: INR78): The company
has reported better-than-expected growth in
volumes in 1H, up 20% y-o-y in a tough
market and is likely to beat its own guidance of
more than 32bn units for FY14 (growth of 12%
y-o-y). The outlook has improved significantly
in the last few months with 1) higher visibility
in long term volumes, which is a key driver of
growth, 2) de-risking the tolling business with
margins protected and 3) much awaited receipt
of old dues from Uttar Pradesh state utility of
INR7.78bn in October 2013.
 LIC Housing Finance (LICHF IN, CMP:
INR215, OW and TP: INR253): While the
overall slowdown in the economy has plagued
the financial services sector in the past few
quarters, the housing finance sector has
remained largely immune, making stocks
such as LIC Housing Finance a stand out in
this space. Improving margins, 18-20% loan
growth over FY14-FY16e and stable asset
quality should drive the stock’s
outperformance, in our view.