How will midcap and smallcaps perform vis-a-vis largecaps going ahead? Mahesh Patil explains
, CIO,
ABSL AMC
, says in the post-Covid period, mid and small-cap companies experienced higher earnings growth compared to large-caps, fueled by increased investment and sector re-evaluation. While earnings growth has converged and valuations have corrected, mid and small-caps still offer a better long-term growth outlook, potentially attracting renewed investment despite higher valuations and risk-reward.
Though you believe that further rate cuts can be a little negative for the banking space in the short term, this is generally seen to be a positive move for discretionary spending. Within that, the auto turns favourable, the sector outlook, along with that the real estate sometimes gets a push. But this time, do you believe this particular thesis will hold true? Are the valuations comfortable for the stocks to take them up?
Mahesh Patil:
There are two parts to it. One is urban and the other is rural. Urban is more dependent on to some extent also on interest rates because a lot of urban consumers have got mortgages and with interest rates coming down that should support over there. So, yes, clearly urban consumption can see improvement if we see more rate cuts, whether it is the mortgage sector, whether it is the auto sector. But the rural economy is also very important and there are some tailwinds there on the consumption side.
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Inflation has been trending down, so the real wages are now looking much better over there. Monsoons have been good. This year the crop output is supposed to be fairly good. All these factors one would expect the rural incomes to be better this fiscal year and that could drive rural good growth. We are also seeing commentary from a few companies coming in that direction. So, given that the outlook for some of these sectors if you talk about whether it is the auto sector, currently the outlook is still weak, we are not seeing any kind of pick up but one can really hope that in the second half after the festive season there could be a pick up over there.
Valuations in some of the sectors are not necessarily cheap, but they are reasonable. We have seen this in some stocks in the sector underperforming. So there is nothing really cheap but rather reasonable valuations. It is more about the delta change. If we see the trend changing, then we could see upgrades in the earning cycle and this sector can start to outperform. But I would be more constructive on some of the sectors related to the rural economy rather than urban consumption.
The grain of truth here is that small and midcap stocks have rich valuations and there is no second view about it. Yet small and midcap stocks tend to outperform and continue to get inflows. Where is this entire cohort of small and midcaps headed?
Mahesh Patil:
In the post Covid period, the earnings growth of the midcap and smallcap companies was much higher than the largecap or the broader market and that was one of the factors.
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Is IT a value buy or a contra buy now? How will NBFCs fare? Mahesh Patil answers
Obviously we had seen a lot of money coming into the sector and we saw a rerating of that sector also. So, it is a combination of higher earnings growth and PE multiple expansion which led to the kind of outsized returns in the small and midcap sector. In the last nine months, we have seen that earnings growth has kind of converged a bit for the midcaps, especially if you look at it compared to the largecaps, it is more or less in line, and valuations have also corrected to some extent. But they are still expensive, especially in the midcap space.
Now, the question is whether the growth in this midcap and smallcap sectors, at least the outlook over there is better than the largecaps. Post the reset that we saw this year, at least on a bottom-up basis, we are seeing that in the midcap and smallcap universe, the earnings growth is slightly better than the largecap companies. If that is the case, then while the valuations are still higher, if they are able to exhibit better growth, then one can see people moving away from mid and smallcaps. That money will start to again come back into the sector and we have seen early trends of that happening.
So, I would say that while the risk-reward is better in the largecap stocks because in a market correction, any kind of a risk-off globally will provide that downside, but in a three-year, five-year view, midcap and smallcap bottom-ups will possibly still in the Indian market see a better growth outlook on domestic side and end up outperforming.
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