Connie D'Souza, like millions of other investors, burnt his fingers in the market mayhem of May with large-cap and mid-cap stocks dwindling to single digits.

Although for a couple of months now, his investments -- especially in large caps -- have recovered as the market is closing in on its earlier highs, D'Souza continues to worry about the mid-cap stocks he has stayed invested in.

Questions like 'will they ever perform again?' and 'if yes, when?' haunting him all the time. And like D'Souza, a large number of retail investors are wondering why mid-cap scrips are not being able to match the performance of large caps in terms of returns.

Again, with the valuations of large-cap stocks appearing stretched, is it the right time to enter or re-enter mid-cap and small-cap counters knowing that they are currently depressed?

Experts are divided in their opinions on this. While some feel that mid caps will catch up with large caps, others are cautious and feel that investors should wait for the second quarter results to get a clearer picture.

The fall and rise

While the Sensex is just 1.53 per cent or 193 points away from its all-time high of 12,612 scaled in May, both the BSE Mid-Cap and Small-Cap indices have to cover a good ground, lagging their record highs by 12.5 per cent (753 points) and 18.7 per cent (1,500 points), respectively.

Further, while more than half -- 53 per cent, to be precise -- of Sensex stocks are currently trading at their all-time high levels, the corresponding numbers are just 11 per cent and 5 per cent in case of the Mid-cap and Small-cap indices, respectively.

In fact, with the May havoc, the scenario has turned dramatically dismal for mid-cap and small-cap scrips as they have since then been hit much harder than their large-cap counterparts.

They fell much faster, especially in June when the Sensex tumbled to its five-month low. Again, when the market started picking, it was frontline stocks that recovered faster than mid-cap counters.

During June-October, while as high as 67 per cent of Sensex stocks gained over 30 per cent, only 50 per cent and 35 per of mid-cap and small-cap scrips, respectively, moved northward. Though mid caps have recovered of late, their rise has not been as fast as the fall was.

Why is it so? Says Vijay Kedia, managing director, Kedia Securities, "Anywhere else in the world, and very much in India, a bull market begins with large caps as they provide good liquidity facilitating easy entry and exit of the stocks."

A bull market goes through three phases -- first, large caps lead the rally, then mid caps follow and, finally, small caps also catch up.

How large caps lead the recovery too becomes clear in what Manish Kanchan, CEO, Ambit Capital has to say. "After a market crash, people want to invest in better-known companies with stable business models and track records rather than in unknown companies," he says.

Deepak Jasani, who is the head of retail research at HDFC [Get Quote] Securities, gives another viewpoint of how frontline scrips happen to lead a market rally. He says in India, after every few months when new investors enter the market, they get started by targeting large caps.

Sectoral performance

Banking, cement, technology and engineering stocks have outperformed the broader market in the current rally, while power, pharma, FMCG and auto scrips have remained laggards to some extent. Metal stocks have turned to be a mixed bag.

Says Ajay Parmar, head of research, Emkay Share and Stock Brokers, "In any market rally, all sectors do not move in tandem, and defensive sectors such as FMCG and pharma tend to lag others."

In the mid-cap category, while banking, cement and real estate stocks have continued to put up a good show, construction, auto ancillaries, IT, pharma, sugar and textile counters have failed to cheer investors.

"Besides investors being cautious, there are fundamental reasons why some sectors in the large-cap category have performed better than the others," says Ravi Chhugani, dealer - institutional equities, Stratcap Securities.

For example, oil and gas companies -- especially marketing companies such as HPCL [Get Quote], BPCL [Get Quote] and IOC, all of which are large caps -- have started gaining attention with the crude sliding from $80 to less than $60 a barrel. The same is the case with automobile companies.

Time to buy mid caps?

Despite their underperformance in the recent past, there are a good number of experts who back mid caps even now. Jasani believes that at present mid caps have more upside potential than large caps.

Similar is the view of Kedia, who says, "Mid-cap and small-cap stocks are expected to witness some action, particularly after the second quarter results after which they might get re-rated. The mid-cap segment provides a huge opportunity in terms of choice as mid caps outnumber large caps by as many as 10 times."

Adds Jayant Pai, vice-president - institutional equity sales, Parag Parikh Financial advisory services, "Several mid-caps have underperformed in the July-September rally. Thus, there is upside potential in many of them."

However, Arun Kejriwal cautions that there could be volatility during the results season.

Best bets

Parmar of Emkay feels that despite a decent run-up in the past few months, cement, capital goods, engineering, IT and banking stocks have room to deliver 25-30 per cent return, on an average, over the medium term. Following is a low down of some of the top picks of experts:

Cement stocks

Cement stocks -- large-cap or mid-cap -- are still hot picks for many market experts.

The demand-supply mismatch resulting in firm prices and higher capacity utilisation is here to stay for at least two more years, irrespective of regional presence.

In September, cement majors like Gujarat Ambuja [Get Quote], ACC and the AV Birla group reported healthy growth of about 16 per cent, on an average, in their dispatch numbers.

Other players are also expected to report similar growth. Cement prices too continue their northward journey. The average price for the July-September period reported a staggering growth of 29 per cent year-on-year at Rs 204 a bag (of 50 kg), thanks to the hectic activity in the housing, infrastructure and industrial segments.

UltraTech Cement [Get Quote], Shree Cements [Get Quote], JK Cement, Madras Cement, India Cement, Mysore Cement and Kesoram Industries [Get Quote] are market experts' top picks. And many of them are trading at reasonable valuations, given the robust growth potential.

Construction stocks

After being bruised badly by the market in the recent past, as they plunged by 20-30 per cent from their peak levels, some construction stocks such as Nagarjuna Construction, Gammon [Get Quote], IVRCL, Era Construction and HCC have recovered marginally, but they are still attractively priced.

Though their performance in the June quarter was not so impressive, despite strong demand, and some companies also faced margin pressures owing to rising input costs, market players are confident about their positive outlook.

In fact, at the end of the June quarter, most companies had healthy order book-to-sales ratio in the range of 3.5-5x.

Textile stocks

The domestic textile industry has failed to deliver returns and has underperformed all sectors despite the immense potential in the business. However, selective stocks such as Gokaldas Exports [Get Quote] and Alok Industries [Get Quote] seem to be good buys at present.

Gokaldas Exports

Gokaldas Exports, the country's largest garment exporter, trades at a P/E of 14x and 10.7x for FY07E and FY08E respectively. Mutual fund houses such as Fidelity and Prudential ICICI [Get Quote] mopped up close to 8 lakh shares in early September at around Rs 625.

The company has drawn an aggressive expansion plan that includes setting up of new units at Chennai, Hyderabad and Mysore, increasing its client base and improving the product portfolio. It also intends to take its garment capacity close to 40 million pieces a year.

Besides, the textile firm will invest Rs 100 crore (Rs 1 billion) in setting up a unit through its group firm Gokaldas Exports Apparel & Textile Park in the 400-acre special economic zone near Bangalore to produce 1.5 million pieces a year.

Alok Industries

After Welspun and GHCL, Alok Industries, a manufacturer and exporter of home textiles, apparel fabrics, garments and polyester yarns, has been another player going in for global acquisitions.

The acquisition of 60 per cent stake in Mileta International of Czech Republic -- with its well-known brands -- for euro 13.97 million, will give the company a foothold in the highly competitive and fashion-conscious European market.

Besides, the third phase of its Rs 1,100 crore (Rs 11 billion) expansion plan is expected to complete by March 2008. All this initiatives will accelerate its growth rate and the stock is available at attractive valuation of 6.5x and 4.9x for FY07E and FY08E, respectively.

Mid-cap IT

The mid-cap IT space is also expected to witness action as the stocks offer value, and the valuation between large- and mid-size scrips has widened considerably.

3i Infotech

The company is a leading player in the IT products and services space. The stock provides a huge upside potential as it trades at an attractive valuation of 12.2x and 9.5x for FY07E and FY08E, respectively. Further, its strong order-book position of over Rs 200 crore (Rs 2 billion), increasing share of high margin products and inorganic growth strategy make it an ideal mid-cap IT buy.

Sasken [Get Quote]

The company's exclusive focus on the telecom space, a list of elite tier-1 telecom customers such as Nortel, Nokia, Intel and NTT and its strategy of offering both services (embedded R&D outsourcing services) and products (software for mobile phones) augur well for its growth.

Further, Sasken's acquisitions of Botnia Hightech and iSoftTech have enabled it to augment its services and client portfolio. Sasken is a major beneficiary of increased telecom outsourcing to cut costs and its sector-specific technical know-how. The stock trades at 22x and 11x for FY07E and FY08E, respectively.

Ship building

Summet Rohra, analyst with Antique Stock Broking, strongly recommends companies in the ship-building industry such as ABG Shipyard [Get Quote] and Bharati  Shipyard, which are trading at P/Es in the range of 10-11 and 7.5-10 for FY07E and FY08E, respectively.

Bharati Shipyard [Get Quote]

The interest in private sector ship-building major, Bharati Shipyard, is mainly on account of the company's entry into the oil rigs business, which is in high demand. Offshoring drilling count in India is expected to double in the next five years with more exploration activities opening up.

Also, there are only a handful of shipyards worldwide that can build drilling rigs. The company is the first domestic player to enter the business.

Bharati Shipyard has tied up with a well-known US-based oil manufacturing firm to develop the same in its new site at Mangalore. The company's current order-book position stands close to Rs 1,500 crore (Rs 15 billion), with the unexecuted position at Rs 1,200 crore (Rs 12 billion) (4.5 times the 2005-06 turnover).

ABG Shipyard

The country's largest private sector shipyard, ABG Shipyard, is even larger than Bharati in size and revenues. It mainly caters to manufacturing of vessels for the petroleum industry, the demand for which is likely to remain strong in the near future for many reasons.

A large proportion of global offshore fleet is over 20 years old and is due for replacement. Also, the volatility in crude oil prices has led to increase in oil exploration activity.

Besides existing facilities, the company is building a new shipyard in Gujarat at a cost of Rs 400 crore (Rs 4 billion) to be commissioned in the beginning of FY09. Its order-book position -- to be executed over the next 30-36 months -- remains strong at Rs 1,625 crore (Rs 16.25 billion).

Other stocks

Gateway Distripark

The shipping and logistics industry is thriving on upswing in the country's foreign trade. Also, volume of containerised cargo handled at the ports is increasing.

This is expected to benefit Gateway Distripark (GDL), the country's largest private sector player in handling, transporting and storage of containers, warehousing of cargo and various other value-added services provided in importing and exporting of cargo in containers.

Though GDL's financial performance in Q1FY07 was not very impressive, analysts are bullish on its stock given its strong position in the robust demand for containerised traffic scenario. The stock has underperformed and is trading at 15x and 12x for FY07E and FY08E, respectively.

WS Industries

The valuation of WS Industries, manufacturer of porcelain insulators for use in the transmission of electricity, makes the stock attractive. At Rs 58.5 it trades at 11.7x and 8.4x for FY07E and FY08E, respectively.

However, Sharekhan values its core business at Rs 60 per share and its realty venture at Rs 80 per share.

The company has devised a three-pronged strategy -- expanding the current capacity of hollow core insulators from 5,000 tonne to 6,000 tonne, setting up of a greenfield plant of 8,500 tonne and stabilising the source of rental income through the realty venture. In joint venture with TCG, the company plans to develop 15 lakh sq ft space into a state-of-the-art information technology park.

Indo Tech Transformers [Get Quote]

Chennai-based distribution and power transformer manufacturer Indo Tech Transformers is expected to benefit from the immense potential in the sector, believes Suresh Parmar, senior associate - equity, Darashaw Broking & Investment Banking.

It has been projected to grow at a robust rate of 16-18 per cent over the next couple of years. The company raised Rs 51 crore (Rs 510 million) through its initial public offering in February this year to fund the expansion of its distribution and power transformer capacity and set up a new dry-type transformer plant.

The Indo Tech stock has significantly underperformed the Sensex ever since its listing in March this year, and is now trading at 11.3x and 8.6x for FY07E and FY08E, respectively.