Mid-caps in capital goods, defence, EMS, renewables may disappoint

There were expectations of Indian companies making ‘easy’ gains and delivery of strong and profitable growth.

With the Nifty inching towards 20,000, the rise of trendy themes is sparking excitement, particularly in mid-cap stocks. However, this enthusiasm comes with a caveat as previous high expectations have led to disillusionment.

In a report titled Narrative to Narrative earlier this week, analysts at Kotak Institutional Equities said they were “bemused by the regular emergence and rapid uptake of investment themes and their disproportionate impact on stock prices of mid-cap stocks.”

The analysts said, in many cases, eventual outcomes turned out to be disappointing versus the market’s initial narrative of strong growth and high profitability for a long period of time. “We have witnessed this in (1) microfinance institutions (MFIs) and small finance banks (SFBs) (2) consumer durables and apparel, and (3) speciality chemicals, where the outcomes did not live up to the narratives,” the report noted.

MFIs/SFBs traded at high multiples throughout 2015-2019 with the belief that their business models were robust enough to generate high and sustainable RoEs for a long time. However, it looks like investors got too excited and overlooked key metrics. Investors ignore the inherent weaknesses of unsecured lending to bottom-of-the-pyramid borrowers, where loss-given default (LDG) can be as high as 100 percent during periods of stress.

"Frequent man-made and natural calamities exposed the weakness of the business model, with high LLPs and dreadful RoEs during periods of stress," the broking firm's July 19 note said.

For instance, Bandhan Bank's return on equity, as per Kotak, has shrunk 50 percent to 11.9 percent in 2023 from 22.9 percent in 2019.

Similarly, the consumer durables and apparel sector experienced an impressive multiple expansion in FY2014-19. The narrative was built on underpenetration and rising per-capita income. However, growth and profitability didn't match the hype, exposing overestimations and underestimations of competitive threats.

From 2013-2019, the China+1 strategy, aimed at reducing manufacturing dependence on China, put the sector on a pedestal. There were expectations of Indian companies making ‘easy’ gains and delivery of strong and profitable growth. However, the reality is far from true. While companies look elsewhere for production, China still has a stranglehold on most of the production.

"Price of all chemicals have come off and the resumption of production of Chinese chemicals is posing stiff competition to Indian players in the market," Abakkus' Sunil Singhani recently said in an interview with Moneycontrol.

Furthermore, foraying into new businesses has led to downgrades for several companies. The fluorine chemistry industry, once dominated by three players, has witnessed at least three new players competing for market share.

Now, the spotlight is on the "manufacturing" sector, with mid-cap companies in capital goods, defence, EMS and renewables witnessing stellar performances. The market narrative predicts a long runway of growth, high profitability, and robust returns. Yet, history cautions investors to exercise prudence, as similar stories in the past have disappointed.