Daily Voice: Won’t be surprised if smallcaps see another wave of correction, says Varun Lohchab of HDFC Securities

Varun Lohchab, head of institutional research at HDFC Securities, thinks there is still some froth in the broader market despite the recent correction and expects smallcaps to slide further.

"While midcaps appear only moderately overvalued, certain segments of smallcap universe are definitely trading ahead of their fundamentals," he told Moneycontrol in an interview. Another wave of correction, which will bring small caps to a much reasonable level, can’t be ruled out, said Lohchab, who has spent 18 years in the equity market. Edited excerpts:

Do you expect the FY25 economic growth rate to beat economists' expectations?

Our house view on GDP is more cautious and, accordingly, we expect GDP to grow in the range of 6.2 percent-6.5 percent in FY25, which is below RBI’s projected growth rate of 7 percent.

Our view considers expected headwinds from a global slowdown, some moderation in urban demand and slower growth in government capex compared to the previous year. Although we expect some recovery in rural demand, assuming a normal monsoon and stable inflation levels, better performance of exports than FY24, and private investment pick-up to become more broad based.

Do you see the Nifty50 hitting the 25,000 mark in the next financial year but only after a major correction?

Currently, the Nifty50 is trading at 20.9x FY25E, which is ~15 percent premium to its long term historical average valuation. This isn’t extremely overheated zone, if we see this in context of historical valuation ranges of the Nifty. Further, this valuation factors in 14 percent YoY earnings growth in FY25 for the index.

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In our view, this growth figure is difficult to achieve unless consumption picks up meaningfully, given benefits of softer commodity and other input costs are largely over.

HSIE estimated earnings growth for FY25 is around 9 percent. Hence, while we don’t believe that any major correction is coming our way, index appreciation is also capped to high single digit percentage levels only.

Do you expect the divestment to increase significantly after general elections?

In the last few financial years, we haven’t seen much momentum at divestment front. Having mentioned this, we believe current scenario is very conducive for carrying out government’s divestment initiatives. After recent run up in PSU stocks, their market valuations are lucrative. In addition, domestic as well as foreign flows are keeping markets and investor sentiments buoyant.

In this situation, we expect divestments to gain pace in certain select pockets.

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Do you expect the earnings growth in Q4FY24 to be better than the previous quarter? The likely hits and misses?

We expect Q4FY24 to be like previous quarter with respect to the earnings growth. This is worth noticing that YoY earnings growth for our coverage universe (around 224 stocks) has been gradually coming down over the quarters in FY24, as benefits of softer commodity and other input costs are waning.

While YoY earnings growth in Q1FY24 was 52 percent, it declined to 34 percent in Q2 and 20 percent in Q3. It is expected to be around 22 percent in Q4 as well. Among sectors, we believe BFSI, cement, pharma and metals are expected to perform well, while chemicals, power and home improvement will disappoint.

Do you expect IT companies to disappoint in Q4 and FY25 outlook?

The Q4 earnings for IT companies are expected to remain weak in the absence of any clear roadmap towards demand growth, however, there is no surprise element in this as this is discounted in current market prices.

Further, we expect H2CY24 to bring in some clarity about demand outlook for IT sector, as expected rate cuts and easing inflation in US could encourage large companies to increase tech budgets and revive postponed projects. This will mean larger deal flows for Indian IT services firms and hence, in FY25, we expect outlook to improve in the second half.

Do you feel the froth has been cleared from broader markets?

In our view, there is still some froth waiting to be removed from broader markets. As per our recent report "Valuation of Indices", Nifty Midcap 100 and Nifty Smallcap 100 are trading at around 120 percent and 144 percent of their respective average historical valuations respectively.

While midcaps appear only moderately overvalued, certain segments of smallcap universe are definitely trading ahead of their fundamentals. Hence, it won’t be a surprise, if we witness another wave of correction to bring smallcaps to a much reasonable level.

Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol.com are their own and not those of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.