Veteran investor Prashant Jain had an exclusive interview with N Mahalakshmi on The Wealth Formula, where he talked about overvaluation in the stock market, mutual fund sentiments and what he thinks about the consumption theme. Edited excepts:
Q: After a four-year bull run, small and mid-caps saw a sharp sell-off, followed by a rebound. Where are we in the cycle?
A: Large caps will likely remain range-bound in the near term, though Nifty should eventually move higher as the economy grows. For small and mid-caps, I’d be cautious. The phase of rapid decline is probably over, but I expect a longer period of slower underperformance rather than a swift recovery.
Q: Has Nifty bottomed out for the year?
A: It’s tough to call short-term movements, but yes, it’s reasonable to assume Nifty has bottomed out.
Q: Within the top 500 companies, how do you assess valuations? How much of the small and mid-cap space remains overvalued?
A: Small and mid-caps are a vast universe, but 7-8 out of 10 stocks still appear overvalued.
Q: Even such overvaluation, you believe the steep fall is over. Why?
A: When stocks fall 30-50%, many sellers exit, leading to a pause in rapid declines. That doesn’t mean underperformance is ending—just that the fall may slow down and stretch over one to two years. Prices can still decline gradually as investors reassess and accept new lower valuations.
Q: How does this market cycle compare to previous ones?
A: Every cycle shows similar signs of excess, even though the sectors involved change. The classic red flags include overstretched valuations, rapid stock price surges, new retail investors entering en masse, large capital raises from savvy business owners and PE funds cashing out, narrative-driven investing—where fundamentals take a backseat and any valuation is justified by a story. We saw all these signs this time as well.
Q: How do these excesses unwind?
A: When stocks flood the market, it overwhelms demand. Primary market activity spikes, absorbing the enthusiasm of momentum-driven investors. Smart money exits, stocks lose momentum, and weak holders capitulate. Sentiment shifts—even low volumes can trigger steep declines. This was particularly visible in small and mid-caps, where prices fell sharply despite limited foreign selling.
Q: Mutual fund flows remain strong at ₹30,000 crore. How can you say sentiment has really changed?
A: Sentiment has changed for direct investors—especially those focused on small/mid-caps and IPOs. The sharp drop in new listings shows buyers have withdrawn.
Mutual fund investors operate differently. SIP money is long-term and continues through cycles. In fact, a downmarket benefits SIP investors, so these flows don’t necessarily reflect sentiment shifts in direct equity investing.
Q: If we look at the top 500 companies, how many remain overvalued?
A: Excluding the top 50-70 large caps, about 60% of mid-caps still appear overvalued. This market was driven by narratives—themes like Make in India, chemicals, China+1, renewables, EVs, and e-commerce. Even within mid-caps, we saw excessive valuations, with companies trading at 70x P/E despite being sizable businesses.
Q: Some narrative-driven stocks (e.g., defense) have rebounded 100-200% after falling 50-75%. What does this signal?
A: Rebounds are natural after steep falls. A rebound doesn’t necessarily signal a trend reversal—each case must be evaluated individually. We are nearing the end of the narrative-driven phase. Going forward, we’ll see wider dispersion in stock performance—not just across sectors but also within them. Stock selection will become critical, and companies within the same sector may perform very differently.
Q: Should one focus on sector selection or individual stock picking now?
A: Both matter. You want to pick strong sectors and then businesses that outperform within them.
Q: Several stocks – the narrative driven ones -- have fallen sharply. How do you decide what to hold and what to sell? Do you follow a checklist?
A: There is a checklist, but applying it correctly is key. Even experienced investors can misapply it. Ultimately, the goal is to assess the future growth potential of businesses and what you’re paying for that growth.
Some key considerations:
Industry Growth Prospects – Understand how fast the industry can grow. For sectors like railways and defense, where the government is the primary buyer, you must gauge its spending outlook.
Competitive Positioning – Does the company have pricing power and entry barriers? If capacity can be easily added, pricing power is limited.
Valuation – What are you paying for the potential growth?
Management & Capital Allocation – How does the management treat minority shareholders and allocate capital?
Q: What’s your view on railways and defense companies?
A: These sectors must be assessed separately. Railways is a tender-driven business with multiple suppliers, whereas defense often has limited competition due to high entry barriers. Defense order backlogs and execution timelines are longer, making them more predictable.
Within defense, different product categories have varying growth prospects. Missiles have long lifespans, while aircraft have shorter cycles, impacting demand. Post-COVID, these stocks were cheap and rallied together, but with P/E ratios as high as 35 even after the correction, there is no way to justify them. The narrative-driven investing phase is now over.
Q: You are an early investor in power stocks – what’s your take there?
A: Power is more sustainable and didn’t get as overvalued as other sectors. It grows like a utility and is priced accordingly. Unlike defense and railways, it lacks a strong investment narrative. Within power, valuation gaps between companies create opportunities. Identifying companies with better growth prospects is crucial.
Q: With narrative-driven stocks losing momentum, where should investors focus? What about consumption stocks post-budget, considering the tax break?
A: The consumption growth story is not straightforward. Small and mid-cap underperformance may create a negative wealth effect, offsetting tax savings. While tax savings amount to $12 billion annually, a 20-30% drop in small and mid-caps could erode $500 billion in wealth, impacting discretionary spending.
Q: But Indians own a lot of gold, which has appreciated. Doesn’t that offset the wealth effect?
A: Gold isn’t typically used for consumption. Stock market gains are more likely to fuel spending, whereas gold is stored wealth. Families with high small-cap exposure may feel the impact more than those with gold holdings.
Q: So you are skeptical about the consumption theme?
A: Growth will continue, as before and not higher, but valuations remain stretched. Some consumer stocks in building products, cables, and paints, even after a 30-50% correction, still trade at 40-70 P/E multiples. Long-term, these valuations are unsustainable. Several stocks in sectors like paints and cables etc are already correcting. Consumer durables – we’ll stay away.
Q: Isn’t competition the reason for the correction in some of stocks in paints, cables etc?
A: Partly, but high valuations made them vulnerable. When a sector trades at extreme multiples, some trigger—like new competition—can cause a correction. High market caps attract new players, increasing competition.
Q: Will consumer stocks continue to derate?
A: Yes, particularly in the small and mid-cap space. Large-cap consumer staples and auto companies at 20-40x P/E are less likely to see major derating. These companies have strong market positions, cash flows, and dividend payouts.
Q: What about large caps overall?
A: Nifty stocks are less likely to derate significantly. Earnings growth expectations have been reset to around 10-12%. India’s cost of capital has declined, making earnings yield versus bond yield comparisons favourable. This should prevent a major Nifty correction.
Overall, mega caps offer a better risk-reward than mid and small caps in this market.
Q: Where do you look for alpha?
A: This market isn’t easy for active managers—there’s limited opportunity to create alpha as valuation dispersion is low in both large and small mid-caps. Valuation dispersion in large caps is quite low, so there's no extreme overvaluation or undervaluation. While small and mid-caps may see high dispersion in performance, currently they are overvalued. I expect Nifty to compound at around 12%—not more. India has a lower inflation, lower profit growth economy with reasonable margins across sectors. Within Nifty, earnings estimates across sectors vary from 8% to 13-14%. But multiples reflect that by and large.
Q: Your top sectoral picks?
A: In Banks: I prefer large banks over smaller ones.
Life insurance: The sector has underperformed, making it worth exploring.
Some stocks may not fit into a specific sectoral theme, so bottom-up stock picking will play a role. Mega-caps offer better risk-reward than other segments.
Q: What worries you the most about markets?
A: Unreal expectations. I expect Nifty to compound in low double digits, and that should happen over time. Otherwise, there’s no major risk.
Q: How do you evaluate the Trump risk?
A: Trump tariffs won’t impact India much. Nifty’s composition won’t see a significant effect. Some sectors and companies may be affected, but the overall market won’t.
Q: What about continued FII selling? Can it throw the large-cap performance out of the window? FIIs hold about 17%—could that drop further?
A: FIIs' influence on markets is waning. They can impact prices while buying or selling aggressively, but annually, domestic investor inflows surpass foreign flows. Large caps bore the brunt of foreign selling. Could FIIs continue selling? It’s possible but not a risk—it's an opportunity. If fundamentals remain intact and stocks get cheaper, it's a chance to buy. Once FIIs stop selling and start buying, markets rise. So, phases of FII selling are opportunities for investors with periodic cash flows or surplus capital.
Q: When discussing large-cap valuations, we always benchmark against historical valuations. Is there an anchoring bias – today’s circumstances are different?
A: Multiples can temporarily come down, but that isn’t a long-term risk. A 17 P/E for 10-12% earnings growth at India’s cost of capital isn’t excessive. Multiples can move up or down in the short term, but they offer enough comfort for long-term equity investment. Over a 3-5 year horizon, Nifty should compound in low double digits, and earnings don’t seem at material risk.
Q: Your firm's name, 3P, stands for Prudence, Patience, and Performance. How do you measure prudence?
A: Prudence means investing in businesses with a right to win and a sustainable competitive advantage while avoiding those facing material risks. It also means not overpaying for good businesses—because even a great business at an excessive price won’t yield returns. Diversification is key.
Q: Patience is widely advocated, but it can also lead to ignoring mistakes. All short-term mistakes become long-term holdings. How do you balance patience with recognising when to exit?
A: That’s why prudence comes first. If you are imprudent, patience won’t help. But if you truly understand a business, the risk of being wrong over time is much lower. If a business is sustainable, has a competitive edge, and isn’t overvalued, patience will be rewarded.
Upon review, if we feel there are fundamental issues or a misjudgment, we exit quickly. We make mistakes, which is why we remain diversified. Mistakes must be small—position sizing is crucial. Our approach minimises large missteps, and we aim to refine it further with tighter benchmarks. But occasional mistakes are inevitable, and we correct them as soon as they are identified.
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