Mutual Funds

Valuations in small and mid-caps have become attractive

Mahesh Patil | Updated on February 24, 2019 Published on February 24, 2019

Volatility in the equity market in 2018 has continued into 2019 as well. On the one hand, global macro concerns have moderated and sentiments for the Emerging Markets have been boosted after the dovish commentary by the US Fed. However, domestic equity market sentiment has been impacted by a mixed third quarter FY19 reporting season and investor concerns in companies with perceived lapses in corporate governance.

State of the economy

The US economy is expected to see a soft landing in 2019. Macro datapoints have started turning weaker as seen in the sharp drop in both manufacturing output and retail sales. Seeing signs of weakness, the US Fed has reversed its stand, while signalling that it will not be raising rates for some time and that it would be flexible in its quantitative tapering programme. Hence, the strength of the dollar should remain capped; this will be a positive for EMs, including India. The US and China are also continuing their negotiations and a resolution on the trade front is expected, which will be beneficial for the global economy.

Although Brent crude prices have rallied more than 30 per cent from their lows, mainly due to supply cuts by the OPEC and coalition, they remain within India’s comfort zone. They are expected to be range-bound between $60-70 per barrel, which is positive for oil importing emerging economies like India. Considering these developments, EMs have continued to see positive inflows over the past month. The rupee has depreciated around 3 per cent in 2019 mainly in response to the rise in crude oil prices. However, India’s CAD is likely to moderate and external stability is less of a concern now. With inflation consistently undershooting estimates, the RBI has cut policy rate by 25 bps and hinted at additional rate cuts this year, which should boost the economy. The Interim Budget has provided a ₹1-lakh crore plus stimulus to the economy.

Budget impact

Direct income support for farmers and tax benefit for the middle-class will benefit sectors like agriculture inputs, consumer staples, small ticket consumer discretionary items like small appliances, retail, two-wheelers, retail-oriented banks/NBFCs. However, considering that the government has cut back on the capex budget for FY20 and being an election year, some slowdown in infrastructure spending is expected.

Nifty companies have shown robust revenue growth in the Q3 earnings. However, operating margins and PAT have been under pressure as companies faced the full impact of rising material prices and energy cost, tightened liquidity, and higher interest cost. Select private and corporate banks, IT, capital goods and infra and consumption-oriented companies reported numbers.

What lies ahead

Broader earnings growth for the market remains supportive. At 17 times the one-year forward P/E multiple for the Nifty, valuations are near their long-term average, providing cushion.

The downside risk to the Nifty is believed to have eased off. However, the market will remain range-bound due to global macro concerns and domestic developments.

While the large-cap Nifty index has been flat year-to-date, the mid-cap and small-cap indices have declined more than 10 per cent.

This is a continuation of what we saw in 2018, wherein the mid-cap and small-cap indices underperformed.

Unlike in 2017 and 2018, the valuation for mid-and-small-cap companies are now at a substantial discount to their large-cap peers.

Also, it has been observed that after a sharp correction, as was seen in CY2008 and 2011, the pull-back in midcaps has also been equally strong.

While global markets have seen a good rally YTD, India has not participated due to domestic concerns around some NBFCs, the mixed Q3 reporting season, and uncertainty regarding the general election.

This underperformance can continue in the near term. However, investors can accumulate equity for the long term. They would be better off doing SIPs/STPs for the next six months rather than lumpsum investments.

It would also be prudent for investors to allocate 20 per cent of their corpus to mid-cap and small-cap funds as valuations in that space have become attractive.

The writer is Co-CIO, Aditya Birla Sun Life AMC

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