Indian stocks at risk of overvaluation amid low-growth environment, warns RBI
"We are definitely seeing froth in the small and midcap stocks. The Indian markets did correct much before the tariff uncertainties and there was a significant correction in the small and midcap space, primarily because of valuations," Nilesh Shetty, portfolio manager, Quantum Advisors told ET.
"But there has been a significant rebound and we are very near to the all-time high, despite the global uncertainties. Earnings in Q1 could also be slower than expected," Shetty said.
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At a broader level, the central bank's Financial Stability Report (FSR) highlighted the potential valuation risks emanating from geopolitics and tariff-related trade displacements, and the current stock prices may not adequately reflect the risks.
Even globally, FSR said, asset valuations in several markets have stayed high relative to fundamentals, despite the recent market turmoil. To justify current valuations, corporate earnings will have to grow at a robust pace, which may be difficult in an uncertain economic environment, FSR said.
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According to the FSR, the Nifty Midcap 100 is expected to grow at 17.4%, but would require a growth of 28% to justify current valuations. Similarly, Nifty Smallcap 100 growth is expected at 16.9%, but would require a growth of 30.6% to justify the valuations.
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'Earnings Must Improve'
Since earnings forecast updates more slowly than market prices, stock prices are yet to reflect the prevailing geopolitical tensions and elevated uncertainty about the direction of tariffs. Therefore, the current valuations may not be reflecting the extent of overvaluation, FSR said.
According to Siddarth Bhamre, head of institutional Research at Asit C Mehta, midcaps now command a higher valuation premium because there is high growth. 'But is this growth high for just 1-2 years or in the longer term?' he asked. Significant capital inflows into mid and small cap mutual funds have been observed, and there is limited availability of high-quality stocks here. Due to this scarcity, investors are likely to pay premium valuations for quality names.
'People are ready to buy quality stocks at much higher multiples in the mid and smallcap segments and quality names here are not enough. There would always be some pockets and some names where we would find good value, but the job of identifying these names is getting difficult everyday,' Bhamre told ET.
The contribution of equity risk premium to returns remains high for midcap stocks. Hence, between earnings revisions and valuation cuts, market impact could be significant in the event of adverse shocks, according to RBI's FSR.
Along with domestic markets, global asset valuations in several markets have also stayed high relative to fundamentals, despite the recent market turmoil.
'Price corrections and elevated volatility of US equities can spill over to other markets, especially emerging markets like India,' the report said. These risks have been concentrated with exposures to a few large technology firms. US Nasdaq is estimated to grow at 19.9%, however, it would require a growth of 26% to justify the valuations.
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