We prefer large caps as small and mid cap valuations remain stretched: Kotak AMC's Harsha Upadhyaya

If you look at recent years, most large and meaningful policy decisions or reforms have come outside the Budget. It is not necessary that every major policy statement comes from the Budget anymore. Over time, the Budget has increasingly become a statement of accounts rather than a platform for significant policy changes.

• Markets to prioritize fiscal discipline, earnings growth, and global cues over Budget.
• Government likely to lower fiscal deficit and outline debt-to-GDP glide path
• Large caps preferred due to elevated mid and small cap valuations

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With major policy reforms now largely announced outside the Budget, markets are expected to look beyond headline announcements and focus instead on fiscal discipline, earnings growth, and global macro cues, says Kotak AMC CIO Harsha Upadhyaya.

In conversation with Moneycontrol, Upadhyay says that he expects the government to stay the course on fiscal consolidation, potentially lowering the fiscal deficit and outlining a debt-to-GDP glide path, moves that could reassure foreign investors even as capital expenditure growth moderates. He adds that valuations remain elevated in mid and small caps, making large caps the preferred bet.

Edited excerpts:

Markets have been volatile due to global geopolitics and uncertainty. What role can the budget play?

If you look at recent years, most large and meaningful policy decisions or reforms have come outside the Budget. It is not necessary that every major policy statement comes from the Budget anymore. Over time, the Budget has increasingly become a statement of accounts rather than a platform for significant policy changes. There will be a roadmap, but the detailed policy measures will likely continue to be announced outside the Budget. Therefore, the Budget alone will not decide the direction of markets.

At the same time, India has been on a path of fiscal consolidation for several years, and that trend should continue. After the sovereign upgrade last year, fiscal discipline becomes even more important. We should see a lower fiscal deficit being budgeted for next year. There is also a possibility that the government introduces debt-to-GDP targets with a glide path over the next three to five years. Both of these would be positive from a foreign institutional investor perspective, for both equity and debt, as they signal that fiscal prudence is continuing while growth remains strong.

Given that the inflation deflator is now lower, nominal GDP growth is unlikely to be more than low double digits. On one hand, you have nominal growth of around that level, and on the other, the fiscal deficit is expected to come down by some margin compared to last year. Because of this combination, one cannot expect very aggressive capital expenditure growth.

How much capex growth do you expect?

Capex growth is likely to be around 10–12%. While this may look lower compared to the 2020–2024 period, when government capex growth was very strong, it is still a significant number on a much larger base. From a fiscal standpoint, this is a decent number.

Which areas are likely to see government spending support?

It will largely be more of the same. Some support for consumption has already come through measures announced outside the Budget. Within the Budget, spending is expected to continue in areas where the government has focused over the last few years, defense, infrastructure, renewables, electronics, manufacturing, railways, and allied sectors. There is unlikely to be a dramatic shift in sectoral priorities.

What are your expectations on taxation, including income tax, indirect tax, and capital gains?

There is very limited scope for tax reductions. The GST framework has already undergone a large rationalization and is on the lower side. Similarly, we should not expect meaningful reductions in income tax or indirect taxes. The hope from the market’s perspective would simply be that taxes are not increased.

On capital gains specifically, market participants always hope for lower rates or favorable changes like indexation benefits. However, lower rates seem unlikely. The next best possible outcome would be no upward revision in capital gains taxation.

How relevant is the budget today in terms of market reaction? Budget-related market reactions are usually very short-lived, at most a couple of trading sessions. Even in years when markets have reacted strongly, either positively or negatively, the impact has faded quickly. This is because many policy decisions now happen outside the Budget, and even when announcements are made, details often follow later. Markets quickly return to focusing on earnings trajectory, valuations, and global macro factors, which are currently driving far more volatility than domestic policy announcements.

How has the earnings season been so far, and what are your expectations for the full season? It is still early to say as not many companies have reported yet. So far, results have been broadly in line with expectations. We expect a moderate improvement compared to the first half of the financial year, including sequential improvement over Q2. This will not be a V-shaped recovery, but rather a gradual, moderate improvement. For this quarter, year-on-year earnings growth of around 8–10% is expected, and current results indicate that this will be met.

What is your broader earnings and market outlook over the next few quarters? Earnings should continue to improve sequentially. For the second half, we are looking at low double-digit growth, and for the next financial year, expectations are around 14–15%. However, valuations are already discounting much of this improvement. Large caps are trading close to long-term averages, while mid and small caps are still trading at premiums. Mid-cap valuations are somewhat justified by higher earnings growth, but small caps are trading at a very high premium despite multiple earnings disappointments in recent quarters. This keeps valuation risk elevated at the broader end of the market.

We had broadly anticipated a global reset in trade rules and regulations. Our exposure has remained focused on domestic businesses rather than globally linked ones, and that positioning continues. Domestic growth remains significantly stronger than export growth, which supports this approach.

How are you positioned across market segments given these valuation dynamics?

We prefer large caps and larger mid-caps at this stage. Mid-caps offer earnings growth that is around two to three percentage points higher than large caps, which can justify slightly higher volatility for medium- to long-term investors. Small caps, however, are significantly ahead of their long-term valuation averages and remain vulnerable to volatility, as fundamentals have not kept pace with prices.

Are there any sectors that could see a meaningful turnaround? Any disappointments?

Private banks are likely to show better earnings growth from FY2027 onwards. Metals could also see improvement over the next couple of quarters, supported by higher global prices, even though demand conditions have not changed materially. Beyond this, most sectors should see moderate improvement rather than dramatic shifts. We are not expecting large disappointments at a sectoral level. Most of the negative surprises appear to be behind us.