Time to change portfolio mix; look selectively in 6 low volatility sectors: Dhananjay Sinha

"The liquidity premium risk is very high in the smallcaps and on a relative valuation basis, we see it at a very elevated level and that can be a risky scenario in the next three to six months," says , MD & Chief Strategist, JM Financial Institutional Securities Limited.

How are you analysing the stagflation-related worries for the market?
There are two risks to the market; one is of course on the earning side and that is a function of what kind of growth one can expect. At this juncture, the consensus estimates for Nifty earnings or earnings in general is fairly robust. What people are expecting is about 20% growth over the next two years after almost like a 40% growth in FY20-FY22.

The other risk essentially comes from valuation and that is where the stagflation thing becomes much more pertinent. So what a stagflation scenario would imply is that globally inflation is on the rise and especially in the advanced market. The average is about 6% and this is way higher than the average of 1.5%-2% that used to exist prior to the Covid outbreak. So it really forces central bankers to withdraw monetary stimulus by way of raising rates, reducing balance sheet size etc. We see that happening across the world, especially in the major markets which are the dominant sources of liquidity in our market. So, there is a valuation implications on them.

Secondly, high inflation also means that growth in general has actually been scaled down because of this whole Ukraine worry and also the fact that even before that, inflation had been rising. There is a sobering impact on growth that people are expecting. Generally, there is a downgrade that is happening globally.

I would say from an India standpoint, it is when India, China, the US and Europe are seeing scaling down of crude. If you have a significantly high inflation, that is impacting your growth and it will have an implications on earnings etc.

From a market standpoint, what it means is that the rise in the valuation that was happening because of the liquidity will be coming off and from the earnings estimate standpoint, will certainly see correction which could be substantial. We are saying it could be almost 20% from where we are today.

The valuations averages that used to exist before 2013 where the PE ratio on a trailing basis benchmark was 18.5%. It had gone up to 24%. We are currently at about 21%. It will go back to 18-18.5% levels as a benchmark comparison on Nifty. Nifty earnings will also taper. These are the broad risks that we are seeing from the market standpoint.

How should one be going about approaching the market on their portfolio front in this kind of a growth which is getting trimmed on the upside and inflation which appears to be sticky? Even if we moderate our return expectations, how can we shield our portfolios?
If we go back in history since the 1990s and try to look at where there was globalisation of global liquidity. We also looked at batches where earnings corrections happened and funneled all of them together and tried to see what kind of situation can rise going forward. Clearly a couple of things stand out in our analysis. Number one, we believe that the ill-liquid sectors which are the midcap and particularly the smallcap sector, are overvalued relative to the largecaps, especially the smallcaps.

As things progress and liquidity narrows, even in India, we believe that the surplus liquidity in the banking system will come off. The smallcap is something that can be exposed to direction in values which can be substantial. I think liquid stocks are something that we need to be in.

Number two from a sectoral standpoint, we found that high beta sectors can be fairly susceptible to volatility. Basically, these are deep cyclical sectors where typically people had good outlook. For example, in the BFSI space, especially the lending business and the NBFC space, where the expectation is that the lending growth will be in the region of 15% to 17% from current levels of 8%. So I think that will be at risk and typically when global liquidity is narrowing and rates are rising, the dollar tends to be stronger, the rupee weaker and that makes the valuation for banking and financial sector more vulnerable to volatility.

Also, what stood out across multiple cycles of narrowing this curve is the industrial and capital goods sectors which are more inclined towards or do better when growth is better. The GDP growth in India could eventually converge to about 4.5-4% range beyond the near term volatility. I would say that may be something like capital goods or industrials, which are highly dependent on economic revival, can also be scaled back. That is where we find another sort of risk.

So I would say that deep cyclical is something I would be a little cautious about. Sectors with better visibility in terms of both earnings and multiples have different kinds of risks. We look at composite of that and we see better possibilities in low beta sectors such as IT, consumer, staples and selectively one can look at pharma, utilities and upstream oil companies this time. So, there are select pockets where there can be low volatility and one can change the portfolio mix.

What are your thoughts on the valuation of midcap and smallcaps? If we look at a 20-year period, there would be two-three years of very high return and then three-four years when they were most unloved. How are the valuations looking like in that pocket now?
There is a difference between midcaps and smallcaps. The midcaps on a relative basis have corrected. The price to book of midcap index versus the Nifty had come down from 70-80% to almost 66%-65%. It is as good as what we saw in 2018 when the correction happened. A little bit of a rally is happening in the last few days but I would say the midcap has corrected quite a lot in terms of relative valuations.

The bigger risk is in the smallcaps where it is still very high. It is something like 76% and at the peak, it was 84%. It is fairly risky according to me. At this juncture, we are seeing FII selling even in the midcap and smallcaps and mutual funds have actually been buying whereas large retail investors beyond the mutual funds are seeing narrowing participation.

So the liquidity premium risk is very high in the smallcaps and on a relative valuation basis, we see it at a very elevated level and that can be a risky scenario in the next three to six months.