No valuation dip expected in mid and smallcap stocks if they deliver on expected earnings growth, says Krishnan VR

Krishnan VR, Chief of Quantitative Research team at Marcellus, believes that valuations of Indian markets are clearly quite extended both compared to history and across various sectors and stocks. However, he opined that as long as mid- and small-cap stocks deliver on expected earnings growth, there won't be any valuation derating. He advises investors to take a contrarian approach over the next three to five years. 

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How do you view the market structure right now?

Valuations are clearly quite extended both historically and across sectors and stocks. Retail investor flows—whether through direct equities or mutual funds—have become increasingly important drivers over the last few years and have survived both elections and multiple regulatory headwinds. 

Most mid- and small-caps and classic “value” sectors, like capex/industrial stocks, have delivered exceptional returns since the Covid-19 period. I believe earnings growth in these sectors or stocks will be keenly watched to see if they can justify their extended valuations.

What is your sentiment on mid- and smallcaps? Should investors continue to accumulate?

As of July-end, the cross-cycle adjusted PE ratio for the Nifty 500 Index, which includes small and midcaps, stood at 45.5x, putting roughly 99.5th percentile of its monthly values since January 2007.

This should not come as a surprise, as small and midcaps have relatively outperformed large caps over the last four years. However, the smallcap and midcap space in India is quite wide, with a large dispersion in earnings growth and fundamentals. So, it is better to look at individual companies rather than generalise based on aggregate index valuations. Many mid and small-cap companies have strong businesses with long growth runways, so there is no reason to expect valuation derating as long they deliver on expected earnings growth.

What should a model portfolio look like in the current market? Top three biggest weights one should add?

I prefer a mildly contrarian approach over three to five years, targeting sectors or stocks with good fundamentals that have been out of favour compared to the broader market over the last few years. Quality stocks (whichever way we define them) have lagged the broader market, so investing in clean, well-managed, and profitable franchises seems attractive from a medium- to long-term perspective.

Are you bullish on the IPO market given the surge in new issues launching? Should investors buy IPOs in the current environment?

IPO issuances typically rise during the bull market phases. Irrespective of market conditions, evidence globally and across time suggests that the initial public offering is not the right time to invest for a number of reasons. In MeritorQ, which is our quant strategy, we avoid investing in newly listed companies for this reason.

Do you believe Nifty's valuation is far and risk-reward favourable?

Aggregate index valuations are still not in unreasonable territory, with the Nifty's 1-year index forward PE still about one standard deviation above its long-term average. Over the long term, earnings growth for large caps can be expected to roughly follow the nominal GDP growth, so double-digit returns over the medium to long term should not be surprising. Extended valuations in some sectors like defence, renewables and other capex-driven plays could be at risk, especially if any delay in execution and resultant earnings disappointments.

Where do you see Nifty headed by December-end?

Predicting short-term stock market movements is a futile exercise. We focus on fundamentals and valuation instead.

What are key risks to market upside this year?

Continued earnings growth momentum in industrial, PSUs and other commodity sectors could offer some upside potential, though it is difficult to quantify how much of the growth expectations are already in the stock prices. 

For example, Nifty 50 EPS has grown by around 22 percent annualised over the last three years, aided partly by post-COVID topline recovery (FY22-23) and then from commodity cool-off (FY23-24). If this growth can be sustained into the future, then investors can expect similar growth in the broad index, assuming no change in valuations from current levels.

What trends should investors should look for in the remainder of the year?

The government has been doing the heavy lifting in terms of capital spending over the last few years. Given the election results, it is to be expected that welfare and revenue spending get higher priority in budgetary allocations going forward. So, even if, as a theme, premiumisation has worked out better coming out of COVID-19, it remains to be seen if this pivot in government spending would favour more mass consumption plays.

Do you expect FPI inflows to continue selling for the remainder of 2024?

It is difficult to say as risks appear balanced in my view. FPI inflows tend to be sensitive to differential between India and US government bond yields. In its annual monetary conference held recently, the US Fed has guided for a lower fed funds rate going forward to protect the US job market and keep the economy on a path for a soft landing. So perhaps there is a lesser risk of outflows due to higher US rates. However, India is relatively expensive compared to other emerging markets, which does not help FII flows.

One piece of advice for new investors

Do not assume that equities are a risk-free asset class. If you look at stock market history, a 10 percent drawdown in any year is not uncommon. Stay disciplined and diversified.

Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of Mint. We advise investors to check with certified experts before taking any investment decisions.