The Sensex and Nifty have recorded significant gains of 12 percent each, drawing the attention of investors. However, the true stars of this year's market rally have been the BSE Midcap and Smallcap indices, which have surged by 28 percent and 31 percent, respectively.
Despite this enthusiasm, Naveen Kulkarni, Chief Investment Officer of Axis Securities, sounds a note of caution. He believes that the market's breadth may be on the verge of narrowing, particularly within certain segments of the Smallcap universe, and these segments are showing signs of exuberance, raising concerns. The concern arises from the fact that many small-cap companies have limited addressable markets, and the implied growth rates derived from their current valuations may not be sustainable over the long term, posing a potential valuation challenge for investors.
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Sharing his views on the market outlook and specific stock ideas, he noted, "The recent market rally has demonstrated remarkable strength in the Small and Midcap sectors, while the Largecap segment has been relatively sluggish. It's safe to say that Smallcap and Midcap stocks have been the best-performing asset classes in FY24, following the FY23 period where Smallcaps lagged behind Largecaps in FY23." Kulkarni further added, "There is growing concern about the market breadth potentially narrowing from current levels, especially in certain segments of the Smallcap space, which are displaying signs of exuberance."
He goes on to emphasise, "Historically, excessive exuberance has not been sustainable over extended periods. The Midcap segment also presents challenges, as both Midcaps and Smallcaps appear to be overvalued, except for specific stocks where caution is warranted. For the long term, this space appears promising, but intermittent corrections are expected. FY23 was a challenging year for small caps, while FY24 has been favourable. These market cycles are typical, and the current exuberance in small caps requires careful consideration, leading to a reduction in portfolio beta in the small-cap sector and profit booking in fully valued stocks."
"The shift is towards midcaps and quality small caps with low beta. Many stocks have surged 2 or 3 times in the past year, but small caps have limited addressable markets, and the implied growth rates from current multiples may not be sustainable over the long term, posing a valuation challenge.", he further added.
Rally Triggered by Strong Q1 Results
The rally was triggered by strong Q1 results, attracting both domestic and foreign portfolio investors (FPIs) to mid and small-cap stocks due to their better-than-expected financials. The robust economic outlook for India further fueled investor interest in these segments, known for their potential to outperform in growing economies.
Caution in the Midst of Exuberance
Kulkarni noted that market breadth may decrease due to pockets of exuberance in the small-cap space "One of the key challenges in the market is valuation. The question is whether the market cap implied by these stocks aligns with their performance. If a stock is trading at 40 times its earnings, it should grow at 17-18 percent, but if it delivers only 12-13 percent growth, it poses a challenge," he added. For instance, he raised concerns about certain defense stocks that have seen substantial gains but may face execution challenges over the long term.
Quality Small Caps Recommended
When asked about quality mid and small-cap picks, Kulkarni mentioned GlaxoSmithline Pharma and Gillette as examples. He emphasised the importance of avoiding stocks with inflated valuations relative to their growth potential.
Large Cap Market Assessment
Regarding large-cap stocks, Kulkarni highlighted that the NIFTY 50's Price-to-Earnings (P/E) ratio is approximately 18x on one-year forward earnings, which is near one standard deviation above the mean. However, the improved Return on Equity (RoE) and increased capacity utilisation suggest that the large-cap segment is reasonably valued and may sustain its growth.
Hot Sectors and Cautious Approaches
He expressed bullish sentiment toward the BFSI sector, PSU microfinance, private banks, auto, auto ancillaries, and consumption sectors. He provided specific recommendations, such as ICICI Bank, SBI, Bank of Baroda, and RBL in the banking sector. However, he advised caution with the IT sector, stating, "The IT sector is approached with caution, as it is the least allocated sector in the portfolio. It's challenging to gauge the sector's outlook until Q2 results are available. Valuations remain high, with the sector trading at a 15-16 percent premium over its long-term average. The sector's performance depends on how Q2 unfolds, and it's uncertain whether the current premium will be sustained."
Key Market Risks
Kulkarni identified several significant market risks in the next 12 months. These include political risks associated with upcoming state and general elections, rising crude oil prices, global inflation concerns, and a lack of imminent interest rate cuts. He emphasized that volatility could increase, making tail risk management crucial for investors.
Portfolio Strategy for the Future
As for portfolio strategy in the coming months, Naveen Kulkarni acknowledges the opposing market forces at play. While overall market valuations are reasonable, the unexpected strength in Small and Midcap stocks presents challenges. A reduction in market breadth without significant changes in overall market levels can pose risks to diversification across different market capitalizations. Therefore, reducing upside potential to manage downside risks is a prudent strategy, which involves lowering portfolio beta. A "flight to quality" approach emphasizing higher-quality investments may be relevant.
Naveen's strategy includes reducing beta, managing tail risks, and increasing quality positions as key components of the strategy, providing reasonable returns over the next 12 months.
“The focus is on managing strategy beta and risk by increasing allocations to quality stocks, known for their resilience in uncertain market conditions and reducing exposure to cyclical stocks susceptible to economic fluctuations. Adjustments will be made as necessary to adapt to changing market dynamics.” Disclaimer: The views and investment tips expressed by investment experts on Moneycontrol are their own and not those of the website or its management. Moneycontrol advises users to check with certified experts before taking any investment decisions.
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