Mid-cap stocks are on a roll. Should you stay invested or cash out?

medium116479337If you have been investing in the Nifty mid-cap 250 index since December 2021, you would have made an annual return of 25%, compared with 13% for the Nifty 50. In fact, for 2024, the Nifty mid-cap 250 has given a return of 30%, against 17% by the Nifty 50.There have been 980 trading days since 2021. Of these, the mid-cap index was up on 872 days, or 89% of the time, when we look at yearly returns on a daily basis. With every passing year, the returns from the mid-cap space have only improved.The average yearly rolling return in 2023 for the mid-cap index was at 20%. The same was 10% for the Nifty 50. Mid-caps have never trended for such a long period, and this is what is confusing many investors. They are waiting for the segment to fall or correct. But so far, there are no indications.On the other hand, mutual fund managers are telling their investors to stay away from the mid-cap segment. But retail investors want to be part of the small- and mid-cap segments because of past return biases.Mid-caps race aheadNot all is well with large-caps. Foreign institutional investors are big investors in large-caps but have been net sellers in the Indian equity markets. Mid-caps are ahead of large-cap companies not just in terms of top-line growth but also are reporting significantly better profitability.Data from Ace Equity shows that the revenue of large-cap companies grew at a CAGR (compound annual growth rate) of 10% in the past five years, while that of mid-cap stocks grew at 11.3%. Mid-caps saw their profitability improve at 32% CAGR, while profits of Nifty 50 stocks rose at a CAGR of 20%.The Nifty 50 is currently trading at a P/E (price-to-earnings) ratio of 22x, which is lower than its five-year average P/E ratio of 25x. On the other hand, the Nifty mid-cap 150 is trading at 44x, which is much higher than its five-year average of 30x, according to market data site Trendlyne.In 2024, the average rolling returns were at 51% for the mid-cap index and 25% for the Nifty 50. Now the big question is, will this trend continue? And if it does, what strategy should investors adopt? medium116463068The dual strategyThe answer is not straightforward. “I think eventually there has to be a mean reversal and large-caps will have to perform. But for the time being, we can also look at both these segments like two asset classes and follow a dual-momentum strategy to detect regime change,” says Anish Teli, managing partner of QED Capital Advisors, a Mumbai-based fund management firm.What Teli is saying is that one can simply continue with the trend. If mid-caps are trending, then investors can continue to invest in this segment and do their rebalancing on a month or six-month basis. If the trend breaks and large-caps start to perform, then investors should move into large-caps. And if the trend for both doesn’t work, then investors can either move into fixed income or gold.The basic idea comes from the fact that statistics show that if a particular index has given good returns in one year, then the chances of the same index giving higher returns the next year are very high. Basically, top-performing assets continue to trend.This is like the classic dual-momentum strategy. Gary Antonacci introduced the dual-momentum strategy in 2014 through his book Dual Momentum Investing: An Innovative Strategy for Higher Returns with Lower Risks. In the dual-momentum strategy, investors buy assets that are trending higher. So, if the mid-cap index is trading higher, then investors buy the index. And if it gives negative returns over a month or two-month period, then the investor shifts to another asset class like gold or fixed income.Antonacci looks at relative momentum indicators to find the best-performing assets. Once he finds the stocks or asset class that is trending, then he buys that asset class or follows an absolute momentum strategy. medium116463158The large betsBut classic mutual fund managers or even PMS (portfolio management services) managers are value investors. Their classic idea is to buy stocks with low P/E ratios. They have their own framework, where they are ready to buy expensive stocks as long as they see far into the horizon and can give a quality status to the stocks. But their ideas have not always worked.Nestle and Asian Paints are considered to be quality stocks that have been the favourite of value and quality fund managers. In the past year, Asian Paints has dipped 30% and Nestle is down 10%. While these stocks have failed to give returns, the Nifty 200 Quality Index 30 has given a return of 25% because IT or software, which account for 32% of the overall index, are giving superior returns. Again, most quality fund managers are sticking to consumption in quality and have avoided IT.Fund managers who have underperformed want to blame the sudden spurt in government spending that happened in 2021 and 2022. Many mid- and even small-cap companies gained contracts, and their stock prices managed to give huge returns.Most professional money managers like companies that have consistent growth and prefer to be in stocks related to consumption or banking and finance. But large-cap consumption stocks as well as banking stocks have not performed for the past three years. Banks account for 30% of the Nifty 50 index and FMCG accounts for 8%. In the past year, the Nifty bank is up 10% while the Nifty FMCG index has risen only 5%. These are two indices that have traditionally given the best returns in the large-cap space.Considering the fact that growth in consumption may not be strong, there are chances that it will take time for these companies to come back on the growth path. Even in the case of banking, credit offtake is yet to improve. But there are banks like ICICI Bank and SBI that have done well and in a way these stocks are in momentum and not in line with the rest of the large-cap index, which is now the favourite of value fund managers.The final cutThe right strategy seems to be to stick to what is working right now.Mid-caps are trending. While there is no need to get an overexposure to the segment, the fact is that since all is not well with large-caps, it looks like this trend will continue for some time.The idea is to use a proper system and adopt a trend-following strategy.