Should you invest in large-cap or mid-cap stocks?

The stock market has been in a down trend for more than a year – losing 25% from its Nov ‘10 peak. Experts suggest that such falls provide excellent opportunities to accumulate strong large-cap stocks. Large-cap stocks are less risky and offer steady rather than spectacular returns.

Most small investors have a penchant for seeking out small and mid-cap stocks in the hope of making multi-bagger returns. But high returns are usually accompanied by high risks. What should small investors do? How to contain risk without missing out on returns?

In this month’s guest post, Nishit looks at the pros and cons, and comes up with an alternative approach.

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The argument will always continue whether to invest in large-cap or mid-cap stocks. One of my friends was asking me this morning whether it would be a good idea to invest in mid-cap IT stocks. It was the trigger for this post.

Mid-caps have several advantages. They are the real multi-baggers. Microsoft and Infosys were mid-caps once upon a time. Mid-caps can be a 10-bagger or even a 100-bagger. Mid-cap stocks carry a greater amount of risk as compared to large-cap stocks. In a bear market, a large-cap may lose 50% of its value whereas a mid-cap can lose as much as 90-95% of its value.

So, how does one address this conundrum? Every portfolio needs to be garnished by a sprinkling of mid-cap stocks, just like our food needs a sprinkling of salt to add to the taste. Just as too salty food is not good for health or taste, too many mid-caps is not good for the health of your portfolio, which leans towards risk.

How does one identify good mid-cap stocks? There are several criteria one must keep in mind.

1. They should have sound business models.
2. They should be generating real profits.
3. They should have good management. This is a very tricky question. How does one see a management to be good? A small investor cannot go and meet the management of a company he likes. One must look through the annual reports and notifications of the stock exchanges. The promoters should not have a shady reputation, or indulge in activities that harm shareholders – such as pledging of shares or dazzling announcements aimed at TV and newspapers.
4. The companies should be generating positive cash flows and providing steady dividends. Steady dividends can be ignored if the business is growing and the promoters are not investing the money in unrelated activities.

Now that we have looked at what criteria to use in selecting a good mid-cap company, the next question is when to invest. In bear markets, mid-caps are battered beyond recognition. Hence, one can follow this strategy. Keep accumulating large-cap stocks on every dip.

For mid-caps, buy only if the Nifty sustains above its 200 day Moving Average for a week or more. 200 day Moving Average is considered the dividing line between bear and bull markets.

Also, depending on one’s risk profile, the allocation has to be done between large-cap and mid-cap ideas. A conservative portfolio can have a 80:20 ratio between large and mid-caps. A more aggressive portfolio can have 60:40 ratio between large and mid-caps.

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(Nishit Vadhavkar is a Quality Manager working at an IT MNC. Deciphering economics, equity markets and piercing the jargon to make it understandable to all is his passion. "We work hard for our money, our money should work even harder for us" is his motto.

Nishit blogs at Money Manthan.)