While mid and small-cap indices are trading at better multiples compared to the long-term mean but they are also not cheap by any means. One should stick to quality midcaps and small-caps.
Currently, Nifty is trading at 21x one-year forward PE, which is 2.6 std higher than the long-term average. We see a huge divergence among the Nifty constituents. Beyond top 10 names, Nifty looks less expensive, Neeraj Chadawar, Head - Quantitative Equity Research, Axis Securities, said in an interview with Moneycontrol’s Kshitij Anand.
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A) A sharp contraction in Q1FY21 GDP, a drop of 23.9 percent vs expected fall of 20 percent has been due to the strictest lockdown compared to the other pandemic affected countries.
The market will look for the GDP recovery in the remaining months of FY21, however, this is not strong enough to offset the shock from Q1.
Timely progress of the monsoon, higher rural spending by the government & Unlock 4.0 are the positive signals for the economy to drive the sentiments towards the upcoming festival season.
However, we need to observe how economic activities pan out going forwards and the direction of the high-frequency indicators.
With limited fiscal space, the government has limited weapons to drive growth, so recovery will be gradual going forward. Nonetheless, the base effect will push up growth in FY22.
Q) Broader markets are back in limelight after 2 years of underperformance. How should one play the theme – should one increase exposure via individual stocks or by mutual funds?A) The broad-based market rally seen in the month of August. While the benchmark NIFTY 50 was up only 2.6 percent for August, the NIFTY midcap 100 and NIFTY smallcap 250 were up 8 percent and 13 percent respectively.
Quality mid and small caps re-rated during the month, continuing the rally seen in the month of July.
The Mid & small-caps have underperformed the large caps from December 2017 onwards and the trend has now started reversing from the month of January and February 2020 as VIX had declined significantly.
Post COVID19, as VIX spiked to absurd levels, the mid and small caps underperformed, but as VIX started declining from June onwards, the mid-caps and small-caps started performing.
We believe that the current trend of mid and small-cap outperformance is sustainable as the performance seems more broad-based across various one-year time horizons.
Thus, we add more high conviction names to our top picks portfolio.
Between individual stocks and Mutual funds, it depends upon the risk appetite of the investor, however, one should diversify the investment to minimize the downside risks.
Since Jan 2020, we have seen mean reversion in two years rolling returns of Midcaps and Small cap rel to Nifty 50
Q) It looks like we are heading towards 12000 and then towards 12400 levels going by the estimate of one of the brokerage house report. The market is discounting a lot of things, but what could upset the appetite of bulls?A) Ample liquidity, stronger FII flows, a Weaker dollar, better than expected Q1FY21 earnings, widened retail participation, increased risk appetite (VIX ~21) are the current drivers of the market.
We see Nifty FY22 earnings at 590 and valuing Nifty at 19x FY22E earnings we arrive at our December NIFTY target of 11210 which provides limited upside potential in the benchmark index; hence it will be critical to invest in quality midcaps and small caps to generate outperformance and absolute returns.
The current momentum could lead the rally to 12000, but we believe that it will not sustain at that level, rather one should play with quality franchises in mid and small-cap space.
Q) What could upset the appetite of bull?The Indian market has run-up by almost 50 percent since March low, and this sharp rally has been supported by excess liquidity in the market especially in developed countries.
Since 2015, the correlation between the S&P 500 and Nifty is very high. In CY2020 it is rising, which shows a recent rally in the Indian market is more driven by the global market.
All the major central banks are keeping the interest rate low and increasing the balance sheet, to keep the economy moving. Historically, the US market has a high correlation with the FED balance sheet.
Higher liquidity infusion has led the market on a higher trajectory which also brings the interest rate down. Due to a reduction in interest rates, a huge amount of flows has shifted to riskier assets, especially equity in order to generate the same return.
This led equity to trade on higher multiples. We believe that the equity will continue to trade on higher multiples for some more time as the US FED recently signalled that these interest rates will keep lower for an extended period of time which reduces the derating risk of PE multiple.
FIIs added USD 6.4/10.1 bn in the last 1m/3m in the Indian equity market. We believe this flow will continue in the emerging market until we see some reverse in the dollar index.
The key risk to this rally is any sign of interest rate reversal, dollar appreciation and slower economic recovery across the segments vs expectation and any sign of the second wave of COVID could hurt the current momentum.
Q) Even after the recent rally do you see any stocks with strong fundamentals and attractive valuations? Any mispriced opportunities which one can look at?A) Currently, the Nifty is trading at 21x one-year forward PE, which is 2.6 std higher than the long-term average. We see a huge divergence among the Nifty constituents. Beyond the top 10 names, Nifty looks less expensive.
Top 10 trading at 25x while remaining 40 trading at 17.4x on 12m fwd PE. Value has been the dominant investment style over the last 6 months.
However, the present outperformance of value may not sustain as the outperformance has reached its medium-term peak, and the growth strategy’s underperformance has bottomed out.
We believe growth will outperform and focus on small and mid-caps can deliver solid returns. Based on the above themes we recommend the following top picks:
ICICI Bank, ITC, Manappuram Finance, Bharti Airtel, HCL Tech, MindTree, Varun Beverages, CCL Products, Aarti Drugs, Biocon, Minda Industries, NOCIL, and Endurance Technologies.
Q) Sectorally, which are the sectors that will produce leaders of tomorrow and why?A) Our 13 Top picks ideas are based on the theme of Digital, Pharmaceuticals, Rural plays, supply chains shifts, consumer staples and small ticket discretionary play.
These themes played well in the last few months and have delivered consistent returns in a tough environment. We continue to believe in our long-term themes & could result in decent returns over the next 12 months.
However, stock picking will be the key factor to deliver sustainable returns in the current environment.
Q) Are you also seeing a scenario where investors are selling funds and using the money to buy into stocks – is that rotation evident?A) We have seen some outflow in mutual fund in the month of July, however it is very early to derive any conclusion on the rotation theme. We continue to watch this space for the next couple of months to make any conclusion.
Q) What is the strategy which one should follow around asset allocation? How much money should one be parking let’s say in overseas funds or stocks?A) Asset allocation is key for long term wealth creation. Returns of asset classes vary in different cycles, asset allocation is a key to reduce risk and maximize returns.
Different asset classes' returns vary during different market events, with the right asset allocation we are able to manage downside risk and maximize our returns. Volatility & drawdowns also reduce once diversification of equity investment into Debt and gold.
We believe that for moderate investors one should have an asset allocation of Equity: 50%, Debt: 35% & Gold: 15%.
One can also geographically diversify the portfolio by investing 10-15% in the overseas market to take advantage of global equities.
Q) There are more than 100-200 stocks daily which hit a fresh 52-week high on a daily basis. What does history tell us when it comes to putting money in stocks with momentum or in the stocks that are hitting 52-week lows?A) We are seeing outperformance of Mid & Small caps over large caps, Sector rotation theme is also playing out well with laggards playing catch up in the month of August.
We also observed that market breadth has significantly improved in August which is supported by: 1) excess liquidity led by almost daily positive FII flows on August, 2) successful launch of the COVID vaccine by Russia, and 3) improved risk appetite in the overall market (Current VIX ~20).
Valuations are challenging, stock picking is the key except for the BFSI sector where there is limited valuation comfort across sectors.
While mid and small-cap indices are trading at better multiples compared to the long-term mean but they are also not cheap by any means. One should stick to quality midcaps and small-caps to generate outperformance and absolute returns.
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