Business Today

Tread with Caution

Investors must think twice before putting money in small- and mid-cap stocks as these have surged even though the main indices are going nowhere.
twitter-logoMahesh Nayak | Print Edition: August 30, 2015
Tread with Caution
Illustration: Ajay Thakuri

The extremely bullish view of 2014, when India's stock markets delivered returns of 30 per cent, is slowly giving way to a quiet realism.

The biggest reason is that India Inc.'s profits remain well below expectations. In spite of this, investors, in search of higher returns, have pushed up stock prices - especially of mid- and small-cap companies - far above what can be justified by earnings. Some experts even go so far as to say that mid- and small-cap stocks are close to entering the euphoric territory. There is also a fear that foreign institutional investors, or FIIs, will take out money from emerging markets, including India, to invest in US markets when the Fed increases rates later this year.

{mosimage}"Everyone is cautious ahead of the increase in US rates," says Sonal Varma, Executive Director-India Economist at Nomura Financial Advisory & Securities, who last week visited Asian countries to meet clients that invest in emerging markets.

{mosimage}"Investors aren't bearish as such but delay in clearance to the Goods and Services Tax and land bills and disappointing corporate performance have made FIIs stay away from Indian equities," she says (See Waning Interest).

"There is no urgency to invest as this market isn't going anywhere in a hurry," says Mugunthan Siva, Managing Director of India Avenue, an Australia-based fund focused on Indian equities. "The next six months will be a clear wait and watch. Cash is king in the medium term," he says.

Some experts even go so far as to say that mid- and smallcap stocks are close to entering the euphoric territory.

Indian fund managers mirror the view. "The Indian market isn't a runaway market, but whenever it goes down, I will be a buyer, and vice versa," says S. Naren, CIO at ICICI Prudential Mutual Fund, India's second-largest fund house after HDFC Mutual Fund.

Pain Point

High valuations of stocks in India are clear from the performance of BSE Mid-Cap (up 27 per cent in one year to July 31) and BSE Small-Cap (up 17 per cent) indices. Both have been touching new highs in the last few days and are showing no signs of abating. The BSE Sensex has risen just 5.5 per cent in the last one year.

One reason for investor interest in smaller stocks is that many large-caps have become highly priced on an absolute basis. For instance, the MRF stock has risen 70 per cent to Rs 41,000 in the last one year. Just because one has to invest as much as Rs 41,000 to buy one share of MRF, many investors turned to alternatives such as TVS Srichakra, a small-cap tyre stock that has risen three times to Rs 2,600 during the period. Similarly, Force Motors has risen three times (226 per cent) compared to 55 per cent rise in the Maruti Suzuki stock. Shreyas Shipping is up 16 times (1,524 per cent) compared to 7.5 per cent rise in the Shipping Corporation of India shares.

Manish Bhandari, Managing Director at Vallum Capital, an investment advisory based in Mumbai, says speculation is fuelling the rally in small-caps, but mid-caps are rising due to re-rating of their price-to-earnings multiples and change in ownership.

Around $150 billion is invested in gold and real estate every year. Experts say 10-15 per cent of this may flow into equities

The future will be dictated by foreign fund flows and global developments. This means investors should expect volatility and move with caution

Though a short correction is likely, the trend of money, both domestic and foreign, entering Indian equities will continue. "Money is moving out of gold and real estate, as these have underperformed, into financial assets," says Nilesh Shah, CEO and Managing Director, Kotak Mutual Fund.

Around $150 billion is invested in gold and real estate every year. Experts estimate that 10-15 per cent of this is expected to flow into equity markets. In the first three months of 2015, inflows into equity mutual funds were Rs 32,255 crore, three times more than the Rs 9,968 crore in the same period last year. "Money is entering assets that have done well. Mid-cap stocks have given impressive returns in the past two years," says Vallum Capital's Bhandari. It is estimated that 30-35 per cent money allocated for equities is finding its way into mid-caps. He says another reason for the interest in mid-caps is the subdued performance of large-caps. "It's difficult to say that the mid-cap space is euphoric. It can correct from here, but that will be a technical correction. One can't compare today's situation to 2008. Back then, the global economy was on the verge of a crash and today it is on a recovery path. Everything, however, boils downs to the performance of companies," he says.

Out of 609-odd companies with a market cap of Rs 4,000 crore and less, 225 have beaten the BSE Mid-Cap index. Of these, 76 have doubled in the last one year. Around 25 have risen between three times and 16 times.

Investors are also taking heart from the fact that the market is not expected to see a sharp fall from here. "The downside is capped. It can fall 15 per cent, but if you have to be in equities, you should have the stomach to digest such dips," says Siva of India Avenue.

{mosimage}That is why even long-term investors are becoming active at mid-cap and small-cap counters. "It's not just traders and speculators, even some mutual funds have been active in the mid- and small-cap space. This is a cause for concern as these companies are becoming more expensive than their large-cap peers," says Shah of Kotak, adding that there's a risk if these companies do not deliver according to expectations.

Half Full or Half Empty?

What about the long term? "India's economy bottomed out last year, but revival will be slow and gradual. India is a great place to invest," says Naren of ICICI Prudential. "Whenever I look at a country for investment, I take five parameters - fiscal deficit, current account deficit, inflation, GDP growth and credit growth. In all these areas, India's macros are top class." To top it up, crash in prices of commodities, especially crude oil, will lead to huge savings of $50 billion for India. The only big factor weighing heavily on markets is the huge debt on books of infrastructure and real estate companies, which is one reason for tepid investment activity and job creation.

{mosimage}"I worry only about infrastructure companies that have not been able to deleverage. Similarly, residential real estate is so expensive that the sector will not get deleveraged soon. I am worried about these two sectors," says Naren. "Corporate performance may revive once infrastructure and real estate companies get deleveraged. The huge amount stuck in infrastructure and real estate sectors is the real worry. Things that can change this situation are reduction in interest rates, fall in prices of real estate or increase in wages."

{mosimage}Interest rates, it seems, are the key. "There is no incentive for companies to invest. The return on equity of India Inc is near its all-time low. For companies to invest, interest rates have to come down or consumption has to rise. Until the corporate performance improves, equity markets will not see a big upmove," says Shah of Kotak Mutual Fund.

{quote}"If India is short on execution, investors will start looking for alternatives. If earnings continue to disappoint and inflation is sticky, it is likely that investors will pull out," says Siva of India Avenue.

The future will also be dictated by foreign fund flows and global developments. This means investors should expect volatility. "Lack of triggers may see the Sensex move in a range of 26,500 to 28,500. For it to cross 30,000, corporate performance has to fire," says Siva.

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