Companies Ascending from Mid-Cap to Large-Cap Category

India’s equity markets are witnessing a structural shift where an increasing number of mid-cap companies are steadily graduating into the large-cap league. The Large and mid-cap classifications are done by SEBI based on the market capitalisation of companies. Large-cap companies are the top 100 companies, while mid-cap companies are the next 101 to 250 companies in terms of market capitalisation. The classification process is fluid and reviewed regularly. Therefore, if the company moves into the large-cap classification, it is not based solely on a short-term increase in the share price. Additionally, the shares cannot simply be valued at a higher price, but must also have sufficient growth in earnings and strength on the balance sheet to support those valuations.

The transition from mid-cap to large-cap is a process driven by three primary factors: revenue growth, quality of the balance sheet, and increased market share. This blog will take you on a journey with some companies currently in the transition phase.

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Why the Mid-Cap to Large-Cap Transition Matters

When mid-sized growing companies transition to being large growing companies, they begin attracting different types of investment dollars from institutional investment clients and global indexation via passive investment flows. 

• The major advantages of continuing to grow throughout this phase are that, as they scale, their risk profile changes.
• The growth trends lead to strong increases in revenue, providing good operating leverage, and are in markets where they are still well under-penetrated.
• The transition phase in the investment community is an ideal time for investors who focus on the underlying fundamentals rather than labels when seeking investment opportunities.

Understanding Market-Cap Reclassification

The funds classification is done based on these criteria:

Key Drivers Behind the Upgrade Cycle

Many structural and company-specific factors contribute to this migration cycle:

1. Earnings Compounding

Companies that have had sustained double-digit growth in revenues and profits over many cycles will have increased their market cap. Therefore, companies that can reinvest their cash flow as effectively as possible will be able to grow at a faster rate.

2. Operating Leverage

As fixed costs become stable, incremental revenue growth results in a disproportionately larger growth in profits and then improves the margin and return ratios of the company.

3. Balance Sheet Discipline

Companies will be able to grow without diluting equity if they have low leverage, can quickly repay leverage, and can continue building capital on the balance sheet.

4. Market Share Gains

Typically, the highest-performing mid-cap companies in each industry will create new high-performing companies from the many fragmented companies in that industry. This gives them pricing power after they have created brand names.

5. Institutional Ownership

With the increase in the amount of shares owned by mutual funds and foreign institutional investors (FIIs), it has increased the liquidity of stocks, the level of governance of the stocks, and the longer-term consistent value of the stocks.

Historical Perspective: Performance During the Transition Phase

Historical data from earlier cycles of the stock market have shown that companies that are going from mid-cap-sized companies to large-cap companies tend to outperform both indices during the transition. When there is less uncertainty and the credibility of the operations is increasing, there will be a lower risk premium assigned to the business; therefore, there will be a steady expansion of earnings multiples.

After the reclassification, returns will tend to return to normalised levels due to moderating growth rates and base effects. This makes it important to focus on timing and the entry valuation of these companies.

Companies on the Verge of Large-Cap Status

Several Indian companies across sectors are currently positioned in the late mid-cap phase, with market capitalisation, earnings scale, and institutional ownership nearing large-cap benchmarks.

Persistent Systems Ltd

Persistent Systems has transformed itself from a niche provider of IT services into a digital engineering company with platforms as its focus. The company's substantial exposure to cloud, AI-enabled solutions, and enterprise digital transformation has supported continued revenue and margin expansion. In addition, the company's improving mix of clients and larger deals provides a greater degree of visibility into the future.

Dixon Technologies (India) Ltd

Dixon Technologies is a major beneficiary of India's electronic manufacturing initiative. The company is successfully expanding its capacity across many areas, such as mobile phones, consumer electronics, and Electronics Manufacturing Services (EMS), which demonstrates its proven execution and discipline in managing its balance sheet.

Max Financial Services Ltd

The holding organisation of Max Life Insurance, Max Financial, will continue to benefit from a deepening of insurance penetration, premium growth, and higher persistency ratios. The insurance industry continues to have a long-term growth track and is supported by financialisation for large-cap growth.

L&T Technology Services Ltd

L&T Technology Services continues to enjoy strong traction in its engineering R&D service offerings, due to the large global movement towards outsourcing in its target sectors, including mobility, sustainability, and digital manufacturing. With a large order book and a strong parent, L&T Technology Services has stability for the long-term future.

Sectoral Themes Driving the Next Wave

Some sectors are still subjectively better positioned than others to produce the next generation of large caps:

Manufacturing & Capex

The PLI schemes, diversification of supply chains, and the recovery of domestic demand have all contributed to the ability of mid-sized manufacturing companies to continue to scale at an accelerating rate.

Financial Services

The growth in the formalisation of businesses and the penetration of financial services into the consumer market will allow asset managers, insurers, and speciality lenders to achieve predictable and sustained compounding returns.

Technology & Digital Services

The presence of differentiated mid-cap IT companies and platforms continues to capture an increasing portion of global spending on technology.

Consumer Discretionary

The combination of premiumisation, recovery of consumer spending in urban environments, and the growth of companies based on brand equity will continue to elevate certain types of consumer products into larger market capitalisations.

Risks and Caveats for Investors

The journey from mid to large-cap can be very profitable, but there are also many risks involved with this type of investment:

• Valuation Excesses: Over-eager investors may bid up prices too far above their underlying values before companies generate earnings.
• Execution Slippages: As companies expand too quickly, management may not have as much time to devote to ensuring that their resources are allocated correctly, causing problems with execution.
• Cyclical Slowdowns: Many sectors may experience significant declines in sales, making it hard for companies to continue to grow their stock prices.
• Liquidity-Driven Rallies: When capital is simply flowing through the stock market without any earnings produced by the businesses, prices will often revert to their historical levels when capital is removed from the market.

Investors should first look at the quality of the business, the company's return ratios, and the stability of the company's balance sheet, rather than reacting to headlines about reclassifications of companies from mid to large-cap.

Conclusion

The move from mid to large-cap is a result of many years of business excellence. The companies that have made the transition from mid to large-cap tend to have strong corporate governance practices, scalable business models, and generate earnings that continue to compound, creating more earnings. 

For long-term investors, finding these types of businesses before a formal reclassification occurs can greatly increase their returns on investment. As the Indian economy continues to grow and capital markets continue to develop, a large number of mid-cap companies will continue to produce large-cap businesses.