Despite Market Jitters, Mid And Small Caps Still Very Expensive: Kotak AMC's Harsha Upadhyaya
A small time-wise correction may not be sufficient for the mid and small caps to go back to their historical averages, he says.
The consolidation in the stock markets might not be enough for the small and mid-caps due to their high valuation, according to Harsha Upadhyaya, chief investment officer-equity of Kotak Mahindra AMC.
The markets have been range-bound and in a consolidation phase over the last four to five months. The valuations in the small and mid-caps have been on the higher side for the past several quarters, he told NDTV Profit's Niraj Shah in an interview. "It's healthy for the markets as well."
Large caps are at 5–6% higher than the long-term averages in terms of valuation at this point in time. Even if there is further volatility in the markets, it is unlikely that there will be a sharp drawdown at these levels, according to Upadhyaya. "However, the mid and small caps still continue to be very expensive."
The mid-caps are about 30% premium than their historical averages and small caps are at a 40% premium, the CIO said. "A small time-wise correction may not be sufficient for the mid and small caps to go back to their historical averages at this point in time."
Upadhyaya underscored that there were no negative surprises as far as earnings for the quarter are concerned. "After a certain amount of volatility in the very short term, we should be again looking at higher levels, given that our economy and corporate fundamentals are looking strong."
Auto Poised For Slowdown?
Upadhyaya pointed out that the growth rate has come off a bit for the domestic passenger vehicles business. Even with these muted numbers, he said, the auto and auto components sector as a whole would be delivering better than market-average earnings growth for the next two years.
But in the very short term, there is a possibility of consolidation due to a lot of expectation being discounted and a huge outperformance in the sector, he said.
Watch The Conversation Here
Edited Excerpts From The Interview:
Both PM Modi and Amit Shah are confident about the election maths. Do you reckon this could ebb a bit of the recent downtick plus volatility that we've seen in the markets last week?
Harsha Upadhyaya: As far as we are concerned, we continue to see this market as one that is in a consolidation phase.
I think in the last 4–5 months, we have been in a range and consolidating well. I think it's healthy for the markets as well. We do understand that the valuations in the small caps and mid caps in that order have been on the higher side for the last several quarters. To that extent any consolidation that takes place in the market is definitely healthy I would say.
As far as the earnings season is concerned, it's not throwing any negative surprises. So we do believe that after a certain amount of volatility in the very short term, we should be again, looking at higher levels given that our economy as well as our corporate fundamentals are looking quite strong.
Is this consolidation phase time bound, or do you reckon that it will end after a further price correction both in large caps as well as the broader end of the spectrum?
Harsha Upadhyaya: If you look at large caps, they are probably at about 5–6% higher than long-term averages in terms of valuations at this point in time. So one can probably say that, even if there are further cuts in the markets, it's unlikely that there will be very sharp drawdowns from these levels, at least as far as large-cap components are concerned.
However, the mid and small caps are still continuing to be very expensive. Mid caps are at about 30% premium to their recent historical averages. I am not considering past 10-15 years of average, but from 2017–18 when the new categories were made and when the flows increased to these segments. If you consider that period to now, even then, mid caps are trading at about 30% premium.
Small gaps are probably trading in excess of a 40% premium to their historical average. So, to that extent, a shallow correction or a small time-wise correction may not be sufficient for big and small caps to go back to their historical averages at this point in time.
So to that extent, even with the current setup, where we have seen markets moving in that range for the last few months, I will say that only large caps are probably looking much better on a valuation basis.
There is still some more time as well as levels to go for mid and small caps to reach the same levels. But we are no one to say that it has to go to historical averages or really attractive levels before it makes a further up move. So any time-wise correction is definitely good, but it may not be entirely sufficient for mid and small caps.
Autos have been the big buzzwords and big gainers, but the commentary from Tata Motors suggests some near-term caution. Maruti, Tata Motors, everybody's talking about inventory and a high base that might impact near-term growth numbers. Are passenger vehicles, after the recent remarkable uptick, poised for bit of a slowdown?
Harsha Upadhyaya: Look at domestic passenger vehicle business. Clearly, the growth rates seem to have come off a bit. It is very difficult to say for how long this will continue.
Even with these kind of muted numbers, we believe that as a sector, auto and auto components will be delivering better than market average earnings for the next two years. So to that extent, they will probably continue to remain outperformers from a medium to long-term perspective.
But in the very short term, there is a possibility that given that a lot of expectations have already been discounted and there has been a huge outperformance of the sector vis-a-vis the overall market, we could start seeing a little bit of consolidation even in the auto segment.
On the flip side, Harsha, there's again the chatter of rural (demand) bottoming out at some point of time, if not already. Some specific companies mentioned it in their commentary. If rural demand for two-wheelers picks up, then do these businesses provide an opportunity despite the run-ups seen already?
Harsha Upadhyaya: Yes, clearly we think, it's possible because the growth rates in the two-wheeler segment for the last couple of years were probably not as good as the expectations, given the weakness in the rural segment and the mass market segment.
There was also a little bit of market share loss to electric vehicles, within the two-wheeler segment where historically the incumbent companies have not been so strong. So overall, I think, that segment didn't deliver as much as probably passenger vehicles in the last couple of years.
When we look at it today, clearly, this is one of the sub-segments within auto that is likely to grow at a much healthier pace, in terms of volume growth. And the margins should also hold up as we have seen much of the competition from the electric vehicles stabilise at this point in time.
Within the automobile segment, this remains the strongest in terms of the demand indicators, as well as in terms of earnings growth trajectory and to add to that, the valuations of two-wheeler companies, at least some of them have been at a much, much more relatively comfortable levels as compared to other segments of the auto market. So I think from here on, within autos, probably twowheelers will probably deliver better results.
What do you think about this whole cap goods capex theme? Are a select band of companies benefiting disproportionately, because of either the technological mode that they have or otherwise?
Harsha Upadhyaya: We need to clearly segment this entire cap goods, engineering, ENC bucket into something where … we are continuously seeing order inflows coming into the entire segment.
However, as you clearly mentioned, there are fewer industrial companies, which are seeing better margin trajectory. Commodities have remained quite subdued in the recent times.
We've also seen operating leverage helping them and lastly, but not unimportantly, the technology edge that many of these companies have because of the strong parentage and the experience of other markets, geographies, etc., is also helping them to kind of see better margins with higher growth and higher improvement in order book.
So that segment clearly is the leader within the entire engineering, cap goods, and construction space.
As for the companies more focused on the construction space, clearly the overall growth continues to be very strong. The order inflows are very, very strong. However, the margins are unlikely to be as strong as that of an equipment manufacturer. Also, there are more vagaries to these margin trajectories, in case of the EPC business or construction business. So that's where we need to differentiate.
However, when you look at it from a top down perspective, all of them—whether it's construction, whether it is pure industrials—are seeing huge inflows into order books. The execution also has improved. Over the last 15 years, there has been quite a healthy focus back on the cash flows and the balance sheet strength.
Many of those, who have been receiving orders at a rapid pace today are the ones which have very, very strong balance sheets at this point of time.
So unlike the 2003–2008 period where order books were growing but not translating into cash flows or healthy balance sheets, this time around, at least in the earlier part of the cycle, you're seeing a clear differentiation and that's leading to better performance of some of these companies.
And, we do believe that we are at an early stage in terms of this entire cycle. If you look at the centre and state capex, that has been continuing at a very healthy double-digit growth on a year-on-year basis and it should continue to trend similarly going forward as well.
We have seen huge improvements in private capacity addition announcements in FY23 and FY24. Our guess is, as you get into a post-election period, many of them will move into the implementation stage and that's when probably the private capex will also start to fire once again.
So, overall, this entire space is looking very, very good and we continue to have overweight exposure to this entire basket.
Pharma seems to have found some favour this time around, Harsha. Selectively some pharma companies and some diagnostic companies have given good commentary. Showing good performance, the stocks are reacting. Is it a bucket that you will look at closely?
Harsha Upadhyaya: Within the traditional so called defensive sectors, IT and FMCG have been continuously seeing headwinds and the expected earnings growth rate over the next couple of years may lag that of the market average earnings.
However, in case of pharma, while it's not a very top down call for us but there are specific pockets within it where we think the earnings growth rate will probably exceed that of the market earnings growth. From a valuation perspective as well, it is not at one of the highest levels that we have seen in the past.
So I think, if we will need to give a little bit of broad defensive tilt to your portfolio or if you want to look at adding some positions within pharma, you will definitely find few specific names within the specific basket and you should be able to see reasonably strong medium-term growth in this segment.
Also, as you mentioned, the sub-segments of diagnostics or hospitals are clearly focus areas as government is continuously looking at increasing healthcare expenditure and also providing healthcare to the entire population of this country.
From a long-term perspective, I think, hospitals and diagnostics clearly have a longer runway for growth. So overall, yes, between the traditional and defensive segments, we kind of preferred pharma at this point.
Since the Covid lows, PSU banks as a bucket have outperformed private banks quite massively. What's your sense about this whole outperformance? With the valuation differential now a lot narrower than what used to be traditionally between private banks and PSU banks, can it reverse?
Harsha Upadhyaya: Well, we're not in the camp of saying that the performances are going to reverse public versus private banks in that sense.
The entire financial space has been finding it difficult to get low-cost funding at this point of time. That's where I think public sector banks scored better than the private counterparts or NBFCs. That's been an advantage in the cycle for them.
Also, unlike the past, their asset quality continues to be very, very strong. In certain cases, probably they're as good as or better than some private counterparts.
So, given all of this, we have seen a very, very superior performance from public sector banks, as compared to private banks in recent times. That also means that the valuation differential that you were referring to has also reduced to a considerable extent. So, from here on, a similar kind of outperformance from public sector over private sector banks may not be the base case assumption.
However, given the fact that there is still a tailwind for them forward, we do believe that they will continue to outperform the overall market. We do have a reasonable mix of private as well as public sector banks within our financials’ exposure across our portfolios.
