Have midcap and smallcap stock indices lost steam? Certain shares may continue to rise | Interview

“We would not like to generalise on the midcap space on an overall basis. There are a few midcap stocks which could still provide upsides in the medium-term post the recent rally,” said Shyamsunder Bhat

After the recent rally that saw Midcap and Smallcap indices outperform the benchmarks, valuations suggest some cooling down at current levels. However, there still are certain midcap and small stocks that may continue to rise, said Shyamsunder Bhat, Chief Investment Officer at Exide Life Insurance, in an interview with Kshitij Bhargava of Financial Express Online. The market veteran with over two decades of experience added that after holding on to his position during the March sell-off he has been treading cautiously during the recent rally. Shyamsunder Bhat added that financials and IT are some of the largest sectoral holdings of Exide Life. Here are the edited excerpt:

• Midcap and Smallcap indices have performed really well in the past few weeks. What is your view of midcap and smallcap stocks at this juncture? 

The Nifty Midcap-100 index, has rallied by around 50%, on similar lines as the Nifty-50, post the sharp sell-off in March this year. Over the past 3 years, the Nifty Midcap-100 index continues to be in the negative territory, and significantly lagging the Nifty-50. In Financial year 2017 and Financial year 2018, we had witnessed the Midcap index quoting at a significant premium in terms of P/E multiples to the Nifty50, thereafter it has been quoting at a discount. Presently it is estimated to be quoting at par to the Nifty-50 multiples, and therefore the rally could stall here until the financial performance improves significantly.

We would not like to generalise on the midcap space on an overall basis. There are a few midcap stocks which could still provide upsides in the medium-term post the recent rally; however one would need to be selective, as the number of such stocks appears to be limited at present levels.

It is interesting to note that over the past 10 years, the returns from large cap equities, midcap equities and bonds appear to be converging, though bonds continue to be slightly higher in terms of returns due to the sharp divergence in performance in the past 3-5 years.

• Earnings were expected to be bad, what do you make of them so far? 

Analysts had significantly lowered their expectations for this set of quarterly (April-June 2020) results due to the lockdown, and therefore the comparison of the actual results has to be viewed in this perspective (absolute numbers themselves have been weak). Therefore we are viewing this set of “better-than-expected” results somewhat cautiously. Topline was expectedly lower, but stringent cost-cutting has helped mitigate the impact on the bottomline, for corporates. Lower fuel costs, lower travel costs, lower A&P spends have helped limit the damage. Some part of this cost-cutting could sustain (but a large part may not) and therefore may not be correct to extrapolate the same in terms of sustainable margins.

• There has been a lot of talk about more young investors taking up stock trading since the lockdown. Do you see this new set of traders causing a disruption in equity markets?

The percentage of non-institutional participants in the volumes in the equity market has spiked to around 70% in the past couple of months,  as compared to a range of 35-55% for the past 3 years. This is concerning, even more so as it is in a period when we are witnessing a contrary picture on their participation through investment vehicles: since the retail participation in mutual funds and ULIPs has reduced during the period : this indicates a much higher level of direct participation in equities by retail investors.

While some investors might be investing directly in equities post some amount of individual research, there is a possibility that a large number of investors could be investing based on momentum or speculation, and there is therefore a risk of eventual undesirable outcomes.  

• Tell us a little about what your investment strategy has been through the pandemic so far?

We had cut our equity exposure due to valuation concerns particularly with growth slowing down, in the few months prior to the pandemic, however we held on to our positions during the sharp sell-off in March. We added to some of our equity exposure post the sharp sell-off when valuations had become compelling. Thereafter, we have been cautious on the markets during the subsequent sharp rally that we have seen, and we have been  cutting some of the exposure again on valuation considerations. The rally has been driven by the substantial liquidity from global Central banks, lower interest rates, measures from the RBI and the Government to address some of the pandemic-related issues, the “better than-expected” June quarter corporate results and a relatively optimistic commentary from some of the corporates, rising hopes of earlier launch of vaccine for COVID-19, and a good monsoon, rather than due to an economic recovery in India.  

Our largest sectoral holdings are Financials, IT, Oil+telecom, and FMCG+retail sectors. Relative to the benchmark Nifty-50, we are overweight pharma and chemicals, and cement sectors. We are underweight in auto, metals and power sectors. We have maintained an approximately 20% exposure to non-Nifty stocks over the past year, purely on a stock-specific basis.  

• Where do you feel the valuations stand right now?

The Covid-19 epidemic appears to be now under control in some of the larger cities, but it has spread to Tier 2 and Tier 3 towns. The rural economy has been resilient thus far due to a lesser impact of Covid-19 as well as a lesser impact of unemployment, and this recent trend of a spread of Covid-19 to areas where healthcare facilities may not be enough, could therefore  pose a concern.  Going forward, equity markets will keenly watch the demand trajectory in the upcoming festive season, now that the phase of the initial pent-up demand is behind us. Commercialization of one or more of the various vaccines to address the Covid pandemic, fiscal measures which could be announced post normalcy, and success in privatisation of PSU companies (“privatisation”, as compared to “disinvestment”) would influence the market in the near-term, while economic recovery (particularly job-creation), sovereign credit rating and global trade issues could influencing factors over the medium-term. 

The Nifty-50 is now only approximately 10% below the earlier highs, and its valuations are therefore at 18xFy22 expected earnings. Valuations therefore appear to be on the higher side, as the 3-year CAGR (Fy19-20,Fy20-21, Fy21-22) is only around 10-11% in earnings, even after factoring in a sharp 30%+ growth in Fy22 which analysts are now expecting after the presently weak Fy21.  While it is correct that we need to look beyond the current Fy21 while evaluating equities, it would be incorrect to consider Fy22’s likely sharp growth in isolation. A 3-year CAGR of the year that has gone by, along with the present year and the next year, could therefore present a correct barometer to judge the valuations of the market.

Investors need to have at least a 3-year outlook, and ideally a  5-year+ outlook while investing in equities.