Indian markets at crossroads: Kotak flags risk of structural derating amid high valuations

Kotak Institutional Equities observes that the recent correction and ongoing underperformance of the Indian market compared to global peers could be either a temporary phase or the start of a more lasting reset in valuation multiples. Sectors and stocks could see further corrections if the latter scenario unfolds.

The Indian market has continued its weak performance and underperformance relative to global markets, echoing trends from the previous year. FPIs have remained net sellers, while domestic institutional investors, representing retail participants, have continued buying, especially through mutual funds. This dynamic highlights polarized market perspectives, it said.

Investors often attribute the Indian market's weakness to high local valuation multiples, lower valuations abroad, and the absence of a significant hi-tech sector in India. However, Kotak warns that more structural issues may be at play, such as disruption threats across sectors and insufficient domestic investment to counter these challenges. They suggest these factors could eventually lead to a structural decline in valuation multiples to levels more aligned with business realities, rather than past highs. The derating has been delayed by persistent, price-agnostic retail inflow.

The behavior of Indian retail investors is seen as critical for the market's future, especially as FPI sentiment remains negative. Sustained high valuations are attributed to continued retail inflows through mutual funds, even as trailing returns have been weak for over a year. It remains to be seen whether retail investors will maintain their aggressive stance or reduce purchases in response to lackluster returns.

On the earnings front, Kotak notes some stability following a period of downgrades. Third quarter FY26 results have generally met expectations, supporting a cautiously optimistic outlook for earnings recovery between FY2026-28. However, certain sectors remain at risk of downgrades, notably automotive and components due to rising metal prices, and consumer discretionary (excluding automobiles) due to subdued household spending.

Kotak Institutional Equities has made several portfolio adjustments as it had added ITC Ltd, with a 200 basis points weight after its stock declined 21% over the last month, now trading at 21.4 times FY2027 expected EPS overall, and 15.6 times EPS for its core tobacco segment after adjusting for non-tobacco operations.

It also has included Max Healthcare Institute Ltd is included with a 150 basis points weight. Despite falling 18% in the last three months, it offers a 13.5% potential upside to Kotak's 12-month fair value estimate of Rs 1,125. The company's execution and growth remain strong, though valuations are elevated at 42.1x FY2027E EPS and 33.7x FY2028E EPS.

It has removed Embassy Office Parks REIT after gaining 20% in 12 months and now showing only modest upside as interest rates stabilise, while Lupin Ltd is excluded due to persistent US generic pricing pressures and anticipated flat EPS through FY2026-28.- The allocation to Cipla Ltd has been reduced by 50 basis points, now standing at 150 basis points.