After a casino, a stockmarket is perhaps the only other place where millionaires are made and destroyed. Since the bull-run began in April 2003, many have become millionaires. An investment of Rs 17,000 in KEC International, made a year back, is worth Rs 1.86 lakh today. If you are among the lucky few who raked in that kind of money, give this article a miss. But if you are among the many who missed the bus, and have been kicking yourself for it, take heart and stop kicking yourself. It is never too late to invest in the market - provided you do your homework.

Let's take what was at the forefront of this rally: the mid-caps. Since the post-election devastation, mid-cap stocks (represented by the CNX Midcap 200 Index) are up by 46 per cent. In contrast, large-cap stocks (represented by Sensex and Nifty) gained just 26-30 per cent.

But mid-caps are not a new find, having been the biggest wealth creators in the last five years (See 'Top Of The Charts'). An investment of Rs 10,000 in January 1999 in a hypothetical mid-cap index fund would have grown to Rs 37,300 by now, compared to Rs 18,600 in a Sensex-based index fund. Even in the future, mid-caps will always be more rewarding than large-caps.

But there is a flip side too. Mid-caps are highly volatile. "Investors must realise that mid-cap is a high-risk, high-return investment," says Nilesh Shah, CIO of Prudential ICICI Asset Management. There have been times when mid-cap stocks have witnessed a sharper fall than the large-cap stocks. Already, the CNX Midcap has fallen by 3.45 per cent from its recent peak. Also remember, you are buying into a small company and you need to give it time to grow, say four to five years. The bottomline is you have to be a long-term investor, especially while investing in mid-cap stocks.

But before we look at how to pick up great mid-cap stocks, let's answer the question foremost in your mind.

Is It Too Late To Join The Race?

Today, only 40 of the 200 stocks that make up the CNX Midcap 200 Index are trading below their book value, down from 120 a year back. Also, 41 mid-cap stocks have a market-cap of more than Rs 750 crore - the upper limit for a stock to be in the CNX Midcap Index.

Market watchers and fund managers feel it's going to be tough to spot mid-cap winners now. And they won't come as cheaply as they did some months back. Anoop Bhaskar, fund manager for Sundaram Select Midcap fund, feels that valuations for mid-cap stocks are stretched over the short term. "At current levels, one will have to work harder to find value among them," adds Prudential's Shah.

Nishid Shah, CIO of Birla Sunlife Asset Management, agrees that some stocks have run ahead of valuations. "But there are several of them which can give double-digit returns for the next few years," he adds.

Even Sundaram Mutual's recent study of mid-cap stocks over 8-year and 12-year periods shows that the overall profitability of mid-sized companies has reached record levels. As many as 63 mid-sized companies have doubled profits since 1991. Their market cap is also close to the historic highs of 1994 and 1997 (indicating a sharp rise in prices). But some of them are available at low valuation - even at current prices.

How To Pick Mid-cap Winners

Most mid-cap companies have a restructuring story around them - the falling interest rates helped bring down cost of operations and become more efficient. Some are niche players pursuing global expansion plans. Some are benefitting from the current economic growth. Their size also enables them to be more responsive to changes.

Still, picking the winners is no easy task. Don't depend on regular stock tips and buy-sell recommendations. Most of the mid-cap companies are lesser known names, aren't widely tracked or covered by the media. So ensure you do your homework. For example, one way to invest in technology sector is to pick up Infy or TCS. But to to find a mid-cap stock, you will have to research more, and find out niche players who have the potential to grow faster than the sector.

Of course, you will need to screen the stocks using the standard stock selection parameters - nature of the business, management of the company, financials, etc. But within these, you will need to find out the triggers that can transform it into a large-cap in the future. So look at:

How strong the business is

Take a television media company and a retailing company. The TV company can grow only by starting new channels. And since there is a glut of channels, an explosive growth seems unlikely in the near future. But considering the boom in retailing, triggered by malls, a retail garment company will have a relatively higher potential. In 2000, retail major Pantaloon had a sales turnover of Rs 134 crore. Trent, a much smaller player, had sales of Rs 41 crore. Today, Pantaloon's turnover is Rs 235 crore and Trent's is Rs 150 crore. The Pantaloon stock has gained a whopping 1,500 per cent and Trent is up by 260 per cent since 2000.

Similarly, technology looked promising in 1998-99. The erstwhile mid-cap stocks like Infosys and Wipro are today's large-caps. The trick is in identifying the most promising sectors, and then the mid-sized companies that are poised to benefit. Look for the trends, socio-economic changes or broad government initiatives. Try to find out what businesses will benefit from these trends and changes. Take the boom in IT-enabled services. IT companies have been the obvious beneficiaries. But the large-scale job growth and the increase in purchasing power have boosted the real-estate sector, which in turn has fuelled the demand for cement and steel sectors.

On the policy front, take the government's keenness to push infrastructure reforms. Apart from huge budgetary allocations, it plans to use forex reserves to fund infrastructure growth. Do some research on which businesses will get a fillip from this and which small and mid-sized companies will benefit. The bottomline is the sector has to show real promise.

How the company compares with big players

An important determinant is the company's position vis-à-vis the leader in the industry. If the leader is formidable and aggressive, the smaller players have to struggle hard. On the other hand, if the leader's slowing, it's easier for the smaller players to grow. In FMCGs, for example, the smaller players have been showing better growth than the leader.

How is the company's financial health?

All the above factors will not help if the business isn't consistently profitable - a big jump in sales, or profits, in one or two quarters will not do. Look at whether the company has sustained the sales growth or profit margins over at least four to five years. Some of the biggest gainers of the mid-cap rally like Sesa Goa and CESC have one thing in common: they have consistently shown higher sales, profit margins, and return on capital over the past five years.

Also, compare their profitability with that of larger ones. ACC's return on capital employed (ROCE) improved from 11.77 per cent in 2001 to 15 per cent in 2004. Birla Corporation had a ROCE of 4.7 per cent in 2001, which has doubled to 13.2 per cent in 2004. It registered a whopping 895 per cent growth in profits last year, as compared to ACC's growth of 99 per cent. So it's the rate of growth that also makes the difference.

Apart from looking at historical performance, look into the future. "Can you foresee a dramatic change in the company's fundamentals over the next two to three years? Is a huge inflexion in profits underway?" asks Jamshed Desai, head of research, IL&FS Investsmart. It is easier to find such triggers in manufacturing than in services. For example, if an engineering company receives a huge order that is two to three times its sales, that is a trigger for a jump in profits over six months to one year.

Increase in capacity or increased utilisation is also a growth trigger. Mercator Lines, a shipping company, increased its tonnage capacity by a whopping 400 per cent during the last fiscal. The result: its topline grew by 290 per cent as against a mere 11 per cent in the previous fiscal. The stock has gained 116 per cent over the last one year. Besides, some fund managers also use quantitative benchmarks. Sundaram Midcap, for instance, picks up stocks that have price-to-earnings ratio of not more than 10, a dividend yield of at least 2-3 per cent, and a consistent dividend payout record for at least three years.

Who owns the stock?

If a promising mid-sized company has not yet been discovered by the big institutional players, it is one reason to pick up the stock. In this rally, foreign institutional investors - apart from domestic players - have bought up mid-cap stocks in big way. But catch such stocks ahead of anyone else, so you get the maximum value when the turnaround happens.

However despite a great stock picking skill, there can be liquidity risks with mid-cap stocks. There are times when these stocks aren't actively traded. In most of these companies, promoters hold a majority stake and a very small proportion of shares are actively traded. Despite the current rally, the daily traded value for each of the 200 stocks of CNX Midcap Index is not more than Rs 10 crore. Vinay Kulkarni, fund manager for UTI Midcap Fund, warns that with the lowering of short-term capital gains tax to 10 per cent, the speculative interest in these stocks will rise. Further, some promoters resort to frequent trading, leading to jacking up of volumes. Thus, one way to mitigate these risks and lessen your burden of research is to go the mutual funds way.

The number of mid-cap funds has gone up from three to seven. Each has its own definition for mid-cap stocks, but usually invest 60-70 per cent in these stocks. However, most of them don't have a historical performance to show. So, look at the performance of other equity funds managed by the same fund house. This should give some indication about its track record.

The fund route will take away the higher risk associated with direct investing, but within the realm of diversified equity funds, mid-cap funds tend to be the most volatile. The way to beat the volatility is to have a long-term horizon and limit your allocation to mid-cap stocks and funds. While you ought to give at least three to four years for the stock to become a large-cap, you can't bet all your horses on them. Experienced players say it should not be more than 15-20 per cent of your total equity investments.