The S&P BSE Sensex, the lead index representing the broader market movement and consisting of large-cap stocks, at 36,748 mid July 2018, surpassed the previous peak reported in January 2018. However, the S&P BSE 500, also largely comprising large caps, is 6% short of its all-time peak of 15,661 in January 2018.

In contrast, the S&P BSE Mid-Cap index needs to travel 3,140 points, or 17.1%, to breach the previous all-time high of 18,321. The S&P BSE Small-Cap index is 4,369 points, or 21.6%, from its historic high. Both the indices recorded historic peaks in January 2018.

Despite the correction, valuations of mid- and small-cap indices are on the higher side compared with the large-cap indices. In fact, the puzzling situation has been continuing for quite some years now. As such, the correction in the mid and small-cap segments was considered overdue. The recent slide has narrowed the divergent valuations between large-cap as against small- and mid-cap stocks. At the current level, the Sensex (36,825) is available at a price-to-earnings (P/E) multiple of 23.10, BSE 500 (14,994) at 25.01, Mid-Cap index (15,664) at 33.28 and the Small-Cap (16,219) index at 106.54.

Two index heavy-weights Tata Consultancy Services (TCS) and Reliance Industries, recently crossed US$ 100 billion in market value, a major milestone for India Inc. Next, TCS announced one of the largest buybacks worth Rs 16000 crore in June 2018. The software solutions provider had launched buyback of similar quantum in the calendar year (CY) CY 2017. Its profit after tax (Pat) jumped a robust 24% in the first quarter ended June 2018.

High valuations continue to be a matter of concern, more so when the equity market is not emanating clear signals. There are multiple concerns. Inflation, based on the wholesale price index, recorded a four-and-a-half year high of 5.77% in June 2018 as against 4.43% in May 2018 and 0.90% in June 2017. Inflation of all the three major components of WPI - primary articles, fuel and power and manufactured products - increased in June 2018. Inflation based on the consumer price index had increased to 4.87% in May 2018 compared with 4.58% in April 2018.

A high inflation trajectory means little scope for the Reserve Bank of India (RBI) to lower interest rates to stimulate the economy through investment and consumption. The central bank might opt to further increase interest rates. It had hiked interest rates in June 2018 after around four years.

Inflation is likely to remain at elevated levels in the short term considering soaring crude oil prices. Also, the increase in minimum support prices (MSP) for kharif (April-September) and rabi crop will keep inflation higher. In July 2018, as promised in the Union Budget for 2018-19, the Central government ramped up the procurement price to 1.5 times the cost of production.

The Indian rupee is under pressure against the US dollar. The Indian currency plunged to an all-time low in June 2018 and breached Rs 69 per dollar. It has lost over 8% in CY 2018 so far to emerge as the worst performing currency in Asia.

Factors leading to weakening of the rupee such as foreign portfolio outflows, prevailing high crude oil prices and the resulting higher oil import bill and the trade war triggered by the US government remain on the horizon.

Crude oil was at around US$ 77.6 per barrel early July 2018. India's basket of crude oil was at US$ 73.8 per barrel. Further, the US dollar is strengthening across currencies. India's widening current account deficit and rising inflation are expected keep the domestic currency under pressure. The tit-for-tat imposition of tariffs by the US and China could spread if not doused quickly. In a latest move, the US in July imposed 10% tariffs on additional US$ 200 billion of Chinese imports. As expected, China plans to announce counter-measures.

A full-scale trade war is unlike to benefit any country or trading bloc. Instead, it could result in global economic slowdown that will not only affect those countries that are retaliating against each other but also those that are bystanders as the efficient and cost-effective value chain will be disrupted. The International Monetary Fund (IMF) has warned that trade wars could cost the global economy US$ 430 billion, or around 0.50% of global growth, by CY 2020.

The stress in the banking system continues to be one of the biggest worries. As per RBI estimates, the gross non-performing assets (GNPA) ratio of scheduled commercial banks could increase to 12.2% by March 2019from 11.6% in March 2018. The system-level capital to risk-weighted assets ratio could decline to 12.8% from 13.5%.

The IMF has revised downwards economic growth projection for India from 7.4% to 7.3% for the current financial year and from 7.8% to 7.5% for the fiscal year ending March 2020 (FY 2020). As per its estimates, the Indian economy grew by 6.7% in FY 2018. Despite lowering of growth projection, India continues to be the fastest-growing economy in the world, ahead of rival China. The economic trend is expected to benefit small- and mid-cap companies to gain in size and strength.

No wonder despite the backdrop of uncertain environment, the potential sponsored by economic growth have ensured the overall stock market's firmness. The Sensex has scaled a new peak though small and mid caps have grossly underperformed.

Thus, the present times could be the opportune time to explore small and mid caps. A sharp correction in these two segments presents an opportunity to enter quality and time-tested stocks at lower levels. Capital Market glanced through the return on equity (RoE) or return on net worth, with emphasis on high RoE over the last five year. Besides, lower volatility in the ratio is equally important. A stable ROE can reflect efforts of the company to protect the shareholders' wealth. Also, companies reporting an increasing trend in RoE over the last five years were shortlisted.

Companies that had paid dividends in each of the last five years were considered. Those with mutual fund presence were preferred. Next, and importantly, RoE was supplemented with high beta value. Companies with beta value equal to or greater than 0.75 were selected as these stocks have the capability to bounce in quick time once the stock market starts recovering. In short, small and mid caps with high and stable or increasing ROE with high beta were explored (see box: The upside and the downside).

As the emphasis is on small- and mid-cap counters, companies with market capitalization less than Rs 5000 crore were considered. Companies that have lost minimum one-fourth in value from their 52-week or multi-year highs were only selected.

GIC Housing Finance, a National Housing Bank- registered housing finance company, reported robust 21.1% growth in housing loan portfolio in FY 2018. Home loans approvals to individuals jumped 34.6% to Rs 3860 crore and disbursement 31.1% to Rs 3621 crore over FY 2017. Over the last four years, total income was up 1.8 times and Pat 1.9 times. Five branches were opened in FY 2018, taking the total count to 69.

The capital adequacy ratio remained comfortable at 16.17% end March 2018 as against 16.60% in the previous year. Promoters include General Insurance Corporation of India (equity stake 15.26%), New India Assurance Company (8.53%), United India Insurance Company (7.35%), Oriental Insurance Company (5.52%) and National Insurance Company (5.49%). RoE has increased consistently, from 16.2% in FY 2015 to 20.17% in FY 2018.

Nocil, the Arvind Mafatlal group company, is the largest rubber chemicals manufacturer in the country. FY 2018 saw the emergence of debt-free status. The debt-to-equity ratio had stood at 0.40 times in FY 2014. RoE has improved impressively over the last five years, from 7.6% in FY 2013 to 17.3% in FY 2018. Revenues spurted 30.4% and Pat 76.5% in FY 2018.

Capex plans worth Rs 425 crore will be executed in three phases: Rs 170 crore in phase I, Rs 168 crore in phase II, and Rs 87 crore in phase III. A significant portion of the capex will be funded by internal accruals. The capex mainly includes expansion of rubber chemical capacities at the Navi Mumbai and Dahej in Gujarat production facilities including captive intermediate consumption to manufacture rubber chemicals. All the three phases are expected to become operational by the first half of the next financial year. The expansion is expected to generate revenues 2x of assets.

Oriental Carbon & Chemicals is one of the world's leading producers and suppliers of insoluble sulphur, a vulcanizing agent used in the rubber industry, especially to make tyres. Insoluble sulphur finds more usage in radial and high performance tyres. Other products include sulphuric acid and oleum, mainly used in the fertilizer, detergent and battery industry. Around two-thirds of the revenue come from exports. Manufacturing facilities are located in Haryana and Gujarat.

Phase II of the expansion of the insoluble sulphur capacity went into production at the special economic zone at Mundra, Gujarat, mid July 2018. The production capacity is 5,500 million tonnes per annum (mtpa). With inroads made into the American market in the recent past, the utilization of new capacities is expected to improve.

The debt-to-equity ratio remained moderate at 0.32 times end March 2018. Mutual funds held 15.05% equity stake as of June 2018. RoE remained in the range of 15.6% to 20.4% in the last five years.

Home textiles maker Himatsingka Seide's business is divided into four segments of drapery and upholstery fabrics, with capacity of two million meters per annum (mmpa), spinning (2,11,584 spindles), bedding (46 mmpa) and terry (25,000 tpa). The retail and wholesale distribution divisions own or have licenses for one of the largest brand portfolios in the home textile space. The requirement of private labels of major retailers across geographies is, too, serviced. A major part of the revenues comes from exports, with North America contributing around 80% to the revenues. The thrust now is on the European region to reduce geographical concentration and bring down revenues from North America to 40%.

The 2,11,584-spindle unit, the world's largest spinning plant under one roof, was commissioned in FY 2018. The home textile portfolio of Global Brands Group Holdings was acquired in FY 2018. The home portfolio includes exclusive licensing rights for the Tommy Hilfiger home brand for North America, the Copper Fit brand and other brands. Construction of a new terry-towel unit began in Q4 of FY 2018.

Among the key concerns is the worsening net debt-to-equity ratio to 1.69 times in FY 2018 as against 1.13 times in the previous year. RoE has increased consistently since the last five years.

Ineos Styrolution India produces ABS and San. ABS is a plastic resin produced from acrylonitrile, butadiene and styrene and used to make home appliances, automobiles, consumer durables and machinery. San is a polymerized plastic resin produced from styrene and acrylonitrile and used for products such as lighting, stationery, novelties, refrigerators and cosmetic packing.

Parent company Ineos Styrolution (revenues euro 5.3 billion in CY 2017) is a global styrenics supplier, with the focus on styrene monomer, polystyrene, ABS standard and styrenic specialties. The parent owned 75% of the share capital, while mutual funds controlled 5.55% equity stake end March 2018.

Navin Fluorine International is an integrated specialty fluoro-chemical producer in the country, with a strong clientele base in India and abroad including global innovators. The four business segments include refrigerants, with revenue contribution of 30% in FY 2018, followed by specialty chemicals (27%), contract research and manufacturing services (25%) and inorganic fluorides (18%).

The capex plan of Rs 115 crore towards creation of additional good manufacturing practices capacity and associated infrastructure is being implemented at the Dewas facility in Madhya Pradesh. The expanded capacities will be utilized for contract manufacturing activities for value-added complex chemicals and fluoro intermediates manufactured for innovator pharmaceuticals producers. The capex will be funded through a combination of internal accruals and borrowings. The new capacity is expected to come on stream by June 2019. The debt-free company's RoE has increased consistently over the last three years. Mutual funds owned 16.82% equity capital end March 2018.

Capital First is an NBFC focusing on financing salaried and self-employed consumers. Also, there are substantial footprints in the micro, small and medium enterprises (MSMEs) space. With presence in 225 locations, the loan portfolio expanded 36% to Rs 26997 crore end March 2018 over FY 2017. Of the total loan portfolio, retail accounted for 94%. Cumulatively, over six million customers have been financed till date. Warburg Pincus holds a significant strategic equity stake. Mutual funds controlled 14.36% equity end March 2018.

The gross non-performing assets (NPA) stood at 1.62% and the net NPAS 1% end March 2018 on a 90- day overdue basis. The overall capital adequacy ratio stood at 15.88% (tier-I capital adequacy at 12.32%) compared with the Reserve Bank of India (RBI)-mandated ratio of 15%. Going forward, the focus will be on long-term loans secured by property, business loans, personal loans, two-wheeler loans and consumer durable loans to drive growth.

Meghmani Organics operates in the three segments of pigments (capacity of 31,890 tpa), agro chemicals, mainly insecticides and herbicides (27,160 tpa) and basic chemicals (1,87,600 tpa). The fourth largest caustic-chlorine producer in the country has over 400 clients. Products are sold in 75 countries, with exports contributing 52% to the total revenues in FY 2018.

Planned expansion, with a capital outlay of Rs 640 crore, involves increase in caustic capacity by 300 tonnes per day (tpa), setting up of a hydrogen peroxide project of 25,000 mtpa and a Dichloro Chlormethane (CMS) plant of 40,000 mtpa. Capex of Rs 650 crore has been incurred in the last five years. Owing to repayments, debt reduced to Rs 385.8 crore end March 2018 as against Rs 461 crore a year ago. Additionally, the cash conversion cycle was down to 54 days in FY 2018 from 75 days in FY 2017. Mutual funds held a mere 0.16% stake end June 2018.

Hester Biosciences is among the country's leading animal healthcare companies and the second largest poultry vaccine manufacturer. The business divisions include live vaccines, inactivated vaccines, health products, disinfectants and sanitizers and diagnostic kits. The products are registered with various countries and international agencies and marketed across India and a few African and Asian countries. The total manufacturing capacity stood at 4.8 billion doses of vaccines in India and another 1.24 billion doses in Nepal. The products are distributed through over 500 distributors in India.

A 55% stake was acquired in Texas Lifesciences Pvt Ltd, a Gujarat-based manufacturer of pharmaceuticals formulations, tablets, capsules, powder, and oral liquid for human and veterinary markets in June 2017. With Africa importing over 80% of vaccines required, the board has approved setting up an animal vaccine manufacturing unit in Tanzania. The proposed plant, with capacity of 1.5 billon doses of vaccines, will be set up at an estimated cost of US$ 18 million. Once operational, the unit is expected clock annual revenues of US$ 30 million.

Skipper operates in the three segments of engineering products (86% contribution to revenues in FY 2018), polymer products, mainly plastic pipes (10%), and infrastructure products including transmission- line engineering-procurement-and-construction (EPC) and water EPC (4%). The engineering products (aggregate capacity of 2,65,000 tpa) include power transmission towers, power distribution poles, transmission lines monopoles, mild steel and high tensile angles, solar structures, fasteners, tower accessories, railway structures and telecom towers. Capacities of the engineering products were increased by 35,000 mt in FY 2018.

Among the largest transmission tower manufacturers in the country and 10th largest globally has a distribution network across the country, with over 5,000 touch points. The order book for engineering products stood at Rs 2627 crore end FY 2018 and is well diversified between domestic, Power Grid Corporation of India, state electricity boards and private players and international orders. International orders accounted for 44% of the total order book end March 2018. Mutual funds owned 9.38% share capital end June 2018.

A foray was made into the railway electrification business in FY 2018 by establishing a presence in the EPC and railway structures segment. In addition, a joint venture has been formed with Metzerplas, one of the largest manufacturers of drip irrigation solutions from Israel, to produce drip irrigation products in India. The entry into the solar structure market was marked by manufacturing ground-based module mounting structures, roof-top mounting structures, module-mounting accessories and seasonal tilt structures at the Uluberia unit in West Bengal.

Food company LT Foods' product basket includes basmati and other specialty rice, organic foods and convenience rice-based products. The miller, processor and marketer of branded and non-branded basmati rice and manufacturer of rice food products in the India and international market is present in India, Middle East, the UK, Europe and the US. Operations include contract farming, procurement, storage, processing, packaging and distribution. The rice product portfolio comprises brown, white, steamed, parboiled, organic, quick cooking brown rice, value added and flavored rice.

Key brands include Daawat, Royal, EcoLife (an organic food brand that includes rice, pulses, oil seeds, cereal grains, spices, nuts and fruits and vegetables) and Heritage. Other brands are Gold Seal Indus Valley, Rozana and 817 Elephant, a recent acquisition. Daawat commands a market share of 35% in the premium basmati rice category. A new rice-processing plant, with capacity of 60,000 tonnes, was commissioned in Rotterdam in the Netherlands in FY 2018. Also, a plant in the US to manufacture organic ready-to-heat products has commenced operations. Mutual funds held 13.24% equity in the small cap end March 2018.

Conclusion

Small and mid caps might witness further correction. The slide in the stocks considered is from their 52-week or multi-year highs. Thus, the loss might appear steeper. Beta in relation to the equity market is a short-term volatility measure and might end up misguiding investors.

Stocks have emerged after exhaustive filtration. However, the process does not guarantee the emergence of good quality companies. Corporate governance remains a key issue. Any further decline in small and mid caps will primarily be due to misadventures of management.

On the positive side, RoE facilitates comparison among a diverse set of companies across industries and market value. It is the most important ratio for the equity shareholders. Considering volatility and uncertainty surrounding the small- and mid-cap category, cautiously exploring stocks is always better. Also, sticking to quality is a must. The exercise requires lot of time and efforts. Last, investment should be undertaken in tranches.