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‘Rally in mid-, small-cap segments led to valuation premium’


NEW DELHI : The sharp rally in the mid- and small-cap segments has led to a valuation premium developing in many companies, which could hamper return potential as markets take a breather. One of the reasons why the broader markets have outperformed is because the mid- and small-cap space is filled with high-quality companies which are able to scale businesses quickly, Shreyash Devalkar, head, equity, Axis Mutual Fund, said in an interview. Edited excerpts:

How do you see rising crude prices and currency volatility impacting the Indian markets?

The cyclicality of crude prices has historically roiled India’s economy, and by extension, its markets. Over the last few years, however, policy changes, the adoption of market-linked prices, and a wider economic moat have reduced this impact to some extent. Today India’s service exports equal, if not exceed, the crude import bill. Favourable long-term contracts and strong geopolitical tailwinds have also stood the economy and the markets in good stead.

On currency, the valuation should be looked at cohesively rather than an absolute dollar-rupee value. In the natural course, currency variations are a result of interest rates and inflation differentials. From an India standpoint, a healthy forex balance, strong exp-orts, and policies promoting import substitution give us confidence that INR (Indian rupee) is likely to remain stable from a relative standpoint. On a year-to-date (YTD) basis up to 31 August, the rupee has lost less than 1% versus the dollar, whereas currencies have swung wildly on both sides ranging from Colombian peso going up 19% and Turkish lira falling 30% during same period.

What other triggers could be on the upside and downside for markets?

There are two ways to look at the markets. At macro level, we can assign companies to three buckets: consumption, investment, and exports. The second is a stock-specific view. Now, if we are to consider market momentum from the macro angle, whether you look at the short, medium, or long term, you find that Indian mar-kets trend in a rather gradual upward trajectory in line with economic growth. The trigger for each category to perform depends on tailwinds or headwinds in each segment. Hence, when any one segment underperforms, other two may carry market momentum forward.

On the downside, there are three triggers that could drive medium-term weakness.

These include global slowdown driving down demand for the export segment, political uncertainty and government policies, and consumption continuing to ebb at a macro level since 2017.

What is driving sustained rallies in mid-cap and small-caps? Is the party likely to continue?

The recent rally in mid- and small-caps has caught several investors by surprise. The longevity of this rally has allowed investors to course correct and reallocate to this space. One of the reasons why the broader markets have outperformed is that this space is brimming with high-quality companies that are able to scale businesses rather quickly. Another way to look at this could be my three buckets analogy. The large-cap space is skewed toward the consumption bucket of the economy while mid and small-caps consist of companies that are more in the investment and export bucket. By virtue of investment and exports being part of the economy outperforming consumption, the broader market rally is outpacing the large-cap segment. A word of caution is warranted for investors looking at deploying fresh assets in this space. The sharp rally in the mid- and small-cap segment has led to a valuation premium developing in many companies. This could hamper return potential as markets take a breather.

How are fund flows likely to pan out towards India and other emerging market peers?

India continues to remain an outlier growth nation even across emerging markets. Active fund inflows coupled with a renewed vibrancy in new-age sectors could set the stage for continued fund flows for India. One aspect of fund flows that adds a feather to our markets is the depth of the market to enter and exit at will. Like in 2022, large investors in 2023 have been able to liquidate large holdings without outsized impact costs. This increases the allure for wider sets of long-term investors looking at India. The ability to exit investments is a critical element when it comes to investment management and investors reward markets where liquidity hurdles and capital controls are limited or non-existent. By comparison, large emerging markets have seen investor interest wane as capital controls have been imposed on foreign investors.

What are some of the themes that could play out? Which sectors or stocks are to be looked at by investors?

Consumption, margin recovery, and the capex cycle are some of the themes. On consumption, our thesis on discretionary consumption has played out from a fundamental standpoint with growth and performance indicators matching internal estimates, Stock price movements have not kept pace for a variety of reasons, and we believe the story could look different in the latter half of FY24 as relative valuations could re-rate from hereon.

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Updated: 10 Sep 2023, 10:49 PM IST

Joanna Swanson

Joanna Swanson is Europe correspondent at the Thomson Reuters Foundation based in Brussels covering politics, culture, business, climate change, society, economies and inclusive tech. With specific focus in breaking news, she has covered some of the world's most significant stories.