DSP MF sees outperformance in small, midcaps; says largecap valuations not cheap

Smallcap and midcap stocks may outperform largecaps going ahead as this segment of the market is priced more attractively on a relative valuation basis, according to a report by DSP Mutual Fund.

The Nifty index is trading at 22 times trailing earnings, while the Nifty Midcap 100 Index is trading at 23 times and the Nifty Smallcap 250 Index is trading at 20 times.

“Small and midcap (SMID) stocks have underperformed Nifty over the last 16 months. The underperformance versus Nifty halted before reaching prior historical troughs. Historically, small and midcap stocks enter a period of outperformance once they reverse from deep phases of underperformance… this opens the room for relative outperformance for SMID, probably small and then midcaps, in that order,” the fund house said in the note.

Largecaps overvalued

According to the fund house, largecaps are trading at above-average valuations.

“Although valuations have pulled back from record levels owing to earnings momentum, they are now above average after the recent rally of the last two months. India’s relative valuation to its emerging market (EM) peers is near record levels,” the fund house said.

Notably, this is largely a function of ultra-cheap valuations elsewhere due to a cloudy outlook in EMs and dismal earnings growth. As outlook for EMs improves, the relative valuation for India may slide lower in the next few quarters. “This doesn’t make India a market to avoid, but to focus more on the SMID segment and bottom up opportunities. India continues to be in a long-term bull market,” it said.

Sectoral bets

The fund house has identified pharma and realty as its key sectoral picks.

DSP MF believes that pharma, and broadly the healthcare sector, is one of the only few sectors that has valuations below five-year average and below pre-Covid levels, making it an attractive investment basket.

“The formulations market in India expanded at a healthy rate. Sustained traction across therapies as well as price increases of 5-7 percent supported overall growth. This trend is likely to continue with some seasonal adjustments and heightened competition,” it said.

On the other hand, the realty sector had seen a large correction recently. This correction was preceded by a breakout in realty stocks from a 15-year consolidation after the crash of 2007-08.

In the last three years, real estate companies in India have undergone a deleveraging cycle with net debt falling 54 percent on an aggregate basis of the constituents of the S&P BSE Realty index.

“Realty is under-owned and a ripe area for exploring bottom up opportunities with valuations being the key focus,” DSP MF said.

Market outlook

Currently, India leads the EM pack in earnings growth but is not cheap on a relative basis. DSP MF says that India may not outperform if momentum favours EMs, but there are enough earnings-driven equity performance in India to continue to remain bullish on India equities.

Further, the report highlighted that foreign institutional investors (FIIs) may turn on their ‘risk-on’ mode. “This usually benefits risk assets such as emerging market equities. FIIs prefer markets where earnings are growing. India is witnessing better earnings growth versus peers,” the fund house said.