Canara Robeco MF’s Shridatta Bhandwaldar on why broad-based mid and small-cap stocks outperformance may be behind us

Despite the odd corrections, the stock markets are near all-time highs and retail investors’ participation has been on the rise. The monthly mutual fund systematic investment plan (SIP) book has already crossed the Rs 10,000 crore mark. But there are headwinds such as rising inflation, possibility of interest rate hikes and steep valuations that make investors think twice before committing their money to equities. In this backdrop, Shridatta Bhandwaldar, Head Equities, Canara Robeco Mutual Fund shares his views on some of the key issues. Excerpts.

Has earnings growth gained momentum?

So far, around 70 percent of the companies have announced earnings (September quarter). Looking at the numbers, earnings growth will continue. At the aggregate level, earnings have improved in the top 200 companies. Earnings expectations going forward are fairly reasonable.

For FY22, the earnings are expected to rise 35 percent and, for FY23, earnings growth is pegged at 15 percent. The earnings growth expectations have not moved much in the last one quarter. Earnings growth is coming from ‘opening up’ of sectors such as financials, housing related segments, industrials, non-auto discretionary consumption. Some of these sectors are coming out of a few years of downturn. The growth is going to be fairly strong.

Many new investors are chasing small and mid-cap stocks for quick returns. Will these segments continue to rise?

When the economy is improving, mid and small-cap stocks tend to do well due to high operating and financial leverage, as compared to larger companies. While earnings upgrades are here, much of those are already discounted with rising stock prices and the valuations are not cheap anymore. Over the next 12 to 18 months, the difference in returns from large and mid-caps should converge. The broad-based outperformance of mid and small-caps is behind us. There could be individual small and mid-cap companies doing well.

While allocating money at this moment, when valuations are steep and earnings expectations are high, one has to look at the margin of safety. Large-caps have not delivered as much as mid and small-caps. If the earnings growth cycle does not play out as envisaged or the risk of economic recovery not playing out materializes, then large-caps may be more resilient compared to their mid and small-cap counterparts. You will be better off allocating more to large-cap. Investors have to keep these factors in mind while allocating their funds.

Retail participation in initial public offers (IPOs) is increasing. Given the stiff valuations, is there money to be made?

Though we have seen stock prices doubling on listing day for some IPOs, given the high subscription numbers, the allotment is low. And hence the impact on the portfolio for both individual as well as institutional investors is minimum, despite all the exuberance. When the valuations of businesses rise, promoters experience the wealth effect.

In many of these IPOs, there is not much of margin of safety. Historically, it has been seen that 60-70 percent of the IPOs do not create wealth. This time, it would be no different. There would be a few good businesses and many others that would fail to deliver in the medium term.

Be it direct stocks or through mutual funds, investors should focus on their asset allocation and hold on to it for longer to create wealth.

High inflation persists here and overseas. What is the likelihood of an increase in interest rates?

Due to the lockdowns to contain the COVID-19 pandemic, many supply chains got disturbed, which led to shortages. At the same time, the government resorted to increased spending and putting money in the hands of the people, leading to higher demand. These two factors have led to inflation. However, going forward, printing of money and government spending are expected to moderate, which will curtain induced demand. The current high prices should also encourage producers to increase supply. This should ensure that inflation comes down over a period of time. For inflation to become entrenched, the economy should be doing extremely well with strong demand and strong job creation, which is not the case as of now.

The challenge is if the inflation becomes entrenched, central bankers are forced to raise interest rates disproportionately and growth collapses. If you get inflation accompanied by strong growth, it will not have a negative impact. In 2003-2007, interest rates were raised but markets did well.

Your fund house is known for focus on quality and growth, which have done well over last one decade. The tide is turning towards value now. You have launched a value fund. Are you going to change your investment style going forward?

Value investing does not mean cheap stocks with low price to earnings ratio. Value for us means buying something where you feel that there is a tangible, time-bound and discernible earnings driver in place for the next six quarters or eight quarters. Many investors buy cheap stocks and those stocks remain cheap forever. That is not value investing.

At Canara Robeco, we do not compromise on the quality of business – balance sheet and of the promoter. Quality and growth are not necessarily fast moving consumer goods, consumer durables or private sector banks. Quality and growth can be in cyclicals as well as structural or compounding businesses.

In our value portfolios, we look for stocks that are cheap in terms of actual share prices, but at the same time, there is a visible change in higher earnings that the company is most likely to earn, going forward.

Sectors such as capital goods or consumer discretionary where the balance sheets, management, valuations were acceptable, but were going through their own challenges in terms of earnings growth seems to be returning in favour. Those parts of the market will be represented more in the portfolios.