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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 a 5% annualized growth 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, so too 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 not every tree can 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. One observation in markets is 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 capitalization for mid-cap or large-cap stocks, a threshold of $5 billion plus can be used to class a company as a large-cap and the range of $2 to $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.

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 to 2000, or infrastructure-related sectors from 2002 to 2007. Once the tide recedes, few among the group are able to sustain the earnings trajectory or continue to maintain high stock price returns.

Now, let us take a look at the list of contenders in 2007, i.e., mid-cap stocks with a market capitalization in the range of $2 to $5 billion, which had the promise to grow into large-caps by now. Out of the 73 contenders, only 14 have managed to move up the ranks to become large-caps, while 41 stocks actually slipped below the threshold of $2 billion market capitalization.

Stocks lose momentum for a variety of reasons. Many are able to grow spectacularly well when they start off from a small base. As size catches up, it becomes difficult to maintain the elevated rates of growth. Often constraints are imposed by the size of the business opportunity, the competitive intensity or the need to continuously reinvest cash flows. In some cases a de-rating may be caused by management action such as a bad acquisition or unrelated diversification. Or some stocks may just fall victim to cyclical swings in the economy.

Many mid-cap funds are launched with the marketing pitch that smaller companies will be able to compound their market caps faster. However, a look at the mid-cap indices suggests that over the last five and 10 years, the mid-cap indices in India have barely managed to outperform the frontline large-cap indices. On a risk-adjusted basis (as measured by the Sharpe ratio—a ratio used to evaluate the performance of an investment while adjusting for risk) the large-cap indices have given similar returns with lower volatility than the mid-cap indices.

This raises the question of 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.

The 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 are low that future returns will continue to sustain for the medium to long term.

To conclude, investors should recognize that attrition is often the rule rather than the exception when they seek to discover the giant sequoias in the stock market.

Amay Hattangadi and Swanand Kelkar work with Morgan Stanley Investment Management. These are their personal views.

Comments are welcome at theirview@livemint.com

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