Sep 08, 2017 10:08 AM IST | Source:

Ambit's Gubbi says it's worth taking profits in small & midcaps as valuations remain punchy

In general, it is worth taking profits of small and midcaps given valuations are punchy even after the recent underperformance.

Although returns on small and midcap stocks depend on earnings growth which can be strong despite a weak economic environment or vice-versa, it is currently worth taking profits on these stocks as valuations look punchy, Pramod Gubbi, Head of Equities, Ambit Capital, said in an exclusive interview with Kshitij Anand of Moneycontrol.

Q) Geopolitical concerns continue to weigh on D-Street. But, history suggests that any dips caused by such news events present a great opportunity for investors? Can we correlate it with war-like situation which gave investors multibagger returns if they invested on dips?

A) Indeed, geopolitical concerns do affect sentiments and rarely affect fundamentals which remain the key driver of stock returns over the long term. Therefore, unless the risk directly affects the business in question, any fall is a great opportunity for investors, especially for those with a longer term horizon.

Q) What is your call on small and midcap stocks which saw double-digit cuts in the month of August? Is it time to bring down holding in these stocks because GDP growth is unlikely to recover soon amid GST implementations?

A) Again, more than lack of GDP growth, returns on small and midcap stock returns depend on earnings growth which can be strong despite a weak economic environment or vice-versa.

But, in general, it is worth taking profits of small and midcaps given valuations are punchy even after the recent underperformance.

Q) Why are FPIs fleeing India? They have already taken close to $2 bn from India equity markets in the month of August. Is it temporary or will the trend continue?

A) Don’t think it is India specific. EM’s, in general, have seen outflows, typical of a risk-averse environment driven by geopolitical concerns.

India may have seen a little more than its fair share of outflows but then India has been one of the best performing EM’s whilst fundamentals in terms of earnings growth recovery remains elusive thereby making valuations hard to justify.

Also, any further talk of western central bank balance sheet unwind should drive more of these outflows.

Q) Indian equities are trading at 21.2x FY18E earnings. All key markets globally continue to trade at a discount to India. However, India’s RoE remains superior to most EMs, an important differentiator for valuation premium. Is it a bullish or a bearish sign?

A) India has historically enjoyed a premium valuation particularly for the superior RoE’s you talk about. However, this RoE premium has been reducing in the recent past which should also suggest that the PE premium should decline too, which hasn’t been the case. Hence, this is a sign for caution

Q) Analysts, as well as research firms, have already started lowering their estimates for GDP growth. The gap between the Nifty’s PE and economic growth is at a 12-year high. Is it time to turn cautious about valuations?

A) I am not sure the Nifty’s PE and GDP growth or the gap between them can be used as a fair metric for valuation. In fact, there is more to equity returns than just economic growth.

Having said that, we have been cautious on valuations for a while now, given the lack of improvement in fundamentals yet stock prices rallying, therefore, making valuations a bit too demanding.

Unless we see any signs of earnings recovering sharply, which we don’t at the moment, we continue to remain cautious.

Q) The market-cap to GDP ratio is trading at its long term average, but valuations of Indian equities remain rich. The Sensex trades at a 12-month forward P/E of 19.2x, at an 11 percent premium to a long-period average of 17.4x. Sensex P/B of 2.8x is at 4 percent premium to its historical average. How should investors read through this information?

A) Again, whilst these metrics are too simplistic to assess the extent of overvaluation, we do agree there is little margin of safety for investors at current stock valuations, particularly given little signs of earnings growth recovering.
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