Small And Mid Caps Have High Valuation But No Margin Of Safety: ICICI Securities' Vinod Karki
In the market, valuations and growth are the two contexts that must be considered, he says.
There is no margin of safety in small and mid-cap investments despite the positive growth lately, according to Vinod Karki of ICICI Securities Ltd.
The rally in the small and mid-cap stocks had occurred previously, notably after the Bharatiya Janata Party's victory in the 2014 Lok Sabha election, Karki, senior vice president of equity research, ICICI Securities, told NDTV Profit.
At the time, the mid and small-cap index saw a rapid increase within a few months, leading to it becoming expensive in comparison with large caps. This bubble eventually burst in 2018, he said. "These higher valuations can persist for a longer duration if growth continues to support it."
Exuberance in mid and small caps is a key concern for Indian equities and may limit their prospective returns vis-à-vis large caps, ICICI Securities had said in a Feb. 16 note.
In the last 12 months, the S&P BSE SmallCap has risen as much as 65% and the MidCap has surged 62%, according to Bloomberg data. Karki also highlighted that this time, the growth is more supportive than in the past.
In the market, he said, two contexts must be considered: valuations and growth.
It cannot be denied that, in terms of valuations, things are considered expensive. Equally important is the acknowledgment that, after a long time, a sustained pace of growth in the profit cycle is being observed, according to Karki.
Valuations are currently at a high level, a situation that arises when growth is occurring at a rapid pace\, he said. The growth is indeed robust, but it does not leave much on the table for investors in terms of valuations, he said.
Pre-Election Rally
The NSE Nifty 50 has experienced a surge of over 2% since the beginning of the year, consistently reaching record highs on a daily basis.
Karki highlighted that the markets are currently expecting a clear mandate in elections, with expectations of continued political reforms. This optimism is driving the markets to achieve all-time highs consistently.
"What could surprise markets is if the election results are not as clear as initially thought to be," he said.
Pocket Of Opportunities
Karki suggested that investors should participate directly in the real-estate cycle by considering investment in lenders and companies engaged in such projects. He emphasised that many opportunities are currently available at reasonable valuations.
From a cyclical perspective, Karki expressed confidence in the banking sector, particularly in large caps.
Watch The Full Interview Here:
Edited Excerpts From The Interview:
Let's begin by getting your take on where we are. So, we've ended a fairly successful Q3 season one would say, though there are divergent views on that. I'd like to know what you think. What in your view is the next big trigger?
Vinod Karki: So, if you see where we are and if you just roll back where we started the year, we were close to this level 21,800 on the Nifty around December–Jan, and we have around 22k. So, it's just a couple of percentage points here and there.
But you have to look at the market in two contexts, one is the valuation, and the other is the growth. So, there is no denying that on valuations, things are expensive. But all equally important is that there is no denying that after a long time, we are seeing the profit cycle continue to grow at a sustained pace. So, if we just see the overall profitability in the system, corporate system in FY23, we were at around 4.3% of GDP and on a trailing 12-month basis. After these Q3 results, we are at 4.9. So, all said and done, the corporate profits are growing at a rate faster than nominal GDP.
There's no question about that and if I look at any forecasts of the indices like Nifty and the other smaller mid cap indices, it's anywhere close to around 30% or that's the forecast I'm getting from 2024–25 perspective. While we know that the nominal GDP will be going around 10–12%. It's faster than nominal GDP. the expansion of the profit cycle is continuing. But as you know, the valuations are at the higher end, which typically happens when growth is at a faster clip. That's how we are currently right now that growth is quite robust. But valuations are not leaving much on the table right now, for investors.
Your report on Q3 says that as far as small caps are concerned, the maximum upside and PAT to GDP left within small caps is at 0.7% versus cycle peak of 1.2%. I want to get your sense on whether some of these earnings really stood the test of valuations because the run-up and anticipation when it came to the actual numbers and corporate earnings, did you see spots of disappointment there?
Vinod Karki: When I see the beats and misses, it was even-steven kind of thing. There were misses in mid caps, small caps and large caps were good. But what I made a point over there is if you believe in our cyclical recovery, the economy is driven by the investment rate, capex cycle, real estate cycle, which typically benefits these smaller companies a lot because they get a good amount of order in terms of capital-intensive sectors. We have seen that the previous profit cycle, which peaked out in 2008, at a peak of around 6–7% of GDP.
If I see where we are right now and where the maximum is, what should I say, if you had a cycle that things peak out at certain point in time, the maximum upside left is still in small gap because they have been affected a lot over the last several years. Several crises have been there and they are coming out of this bad situation. In terms of where they are and where they can go, there is a lot of steam left purely on a cyclical basis where the whole capex cycle is picking up which typically tends to benefit the smaller companies. So I think the growth is there. It shows up in the estimates also when I look at the Nifty mid-cap or the small-cap estimates, where the growth is in twenties as compared to 17–18% estimated growth for the Nifty 50.
So, there is this element of higher growth in all trailing phases, as a lot of expectation is there. On a cyclical basis, it seems that there is steam left in terms of earnings growth for this space.
Let's come to the second part of what you said in terms of valuations, and how much of that value is actually left on the table. So, I was having a conversation yesterday and there was an interesting quote that came up to describe the markets right now, which is it's a bit like you come late to the party and the best food and drink is over and then you know you're sort of rifling through the leftovers to see what you can find. Do you get that sense or are there enough spots of, you know, fairly valued companies still there or you just have to now live with the current valuations and expect earnings to catch up?
Vinod Karki: I think it's still the latter that you have to live with higher valuations, because when I look at my framework of relative valuation of small and mid caps over large caps, it is at the most unattractive zone from a cyclical perspective, though there is no margin of safety in small cap mid cap, there is no question about that. They are in fact, clearly trading above large caps.
But as I said, if you see past instances where these such situations happened. Such situations happened after the first Modi election between 2014 and mid cap, small cap indices went up within a matter of few months 70–80% of an index, they're not good stocks, and they became expensive compared to large cap and what we saw is that after 2018 was when after four years that bubble burst. So, these higher valuations can remain longer. Several years in fact, if the growth continues to support it.
That is the point I mean, in fact this time around, the growth is more supportive than it was earlier because earlier in 2014 to '18, there was an investment boom or real estate cycle boom in fact was failing. But this time it's rising. So that's something on their side, but there's no margin of safety, where you can have very high alpha from this space but you can’t say they are going to collapse. They may tag along Nifty, the large cap kind of returns. That's possible.
So, anyone who has been waiting for that correction for the last many months is, I suppose, still waiting. You mentioned the real estate cycle turn and you've said it a couple of times. Do you think that there are still fairly valued companies in that space which have not run ahead of expectations because if you look broadly, the earnings were fine, but in some cases, there were some disappointments in terms of scale of execution, in terms of cost of inputs. These are things that real estate players are also struggling with. Anything that you like or an outlook you have on the space in the listed category?
Vinod Karki: Yes, so the real estate cycle for sure is I think the second year into the cycle can last five to six years or even higher, depending on the structural strength. But the stocks I think most people look at our coverage of were the prices affecting this huge upside.... But the way to play real estate is, I think, to the supporting companies.
For example, if you look at banks, you know, which will be lending to the real estate market cycle.... If you're saying that there's going to be a rReal estate cycle, obviously mortgage lending will be a good sector and you have lot of financial companies and large companies, which are at very reasonable valuations and building material companies you know, where some of them in our coverage are reasonably valued. I think you have to play more directly in the real estate cycle to lenders and the guys who build out these real estate projects, which are available at reasonable valuations.
I think there were two three headlines from the results, I.T. companies didn't do as badly as was expected and private banks did worse than was expected. HDFC Bank being on top of that heap. Now you're seeing a bit of a sentiment turn around. Would it be fair to say that the next leg of the rally is coming from private banks and the large ones of that?
Vinod Karki: On cycle perspective, I am extremely confident about the banking sector as such, especially large caps and that relatively the private banks if you see their long-term valuation, they are invincible valuations on a cycle perspective and as a cycle.
If you look at the NPA cycle, we're still bottoming out on the NPA cycle not yet on the bottom, it's in FY24. We'll be following the bottom of the NPA cycle, whereas the capex cycle is just not picking up. So in the previous cycle, if you see between 2003 and 2008, was largely the profit-static cycle, the deleveraging in the corporate sector which led to huge gains in growth for banks, that's yet not picked up. Yet some double-digit growth in that space while retail is what is driving whatever growth is there.
So, I think combination of where we are in the cycle, both on valuations and growth trajectory and NPA cycle, I am extremely confident on banking as such, specially some of these quality large cap banks. I think that's a good space to be I mean, if you map it, private or public private.
Because prudent pay are the ones in favour, not so much as private banks, but you're saying both?
Vinod Karki: Both. I would prefer the larger banks because we can expect that they have the wherewithal to really absorb the growth in the good cycle and wherever they have shown the ability to underline it in a prudent pay because the biggest risk with banks is the underwriting issue basically. Can they keep NPAs, you know, limited when the cycle turns? Because growth anyways will come, the credit growth will come up.
We have seen in the past cycle when the credit growth really picked up due to the deleveraging cycle. Credit growth was almost two times of nominal GDP. So one cannot say that this will not happen again. There 0may be a time over the next two–three–four years, where credit growth might be much higher than nominal GDP. Given the way the economy is progressing and we're getting GDP upgrades, there is no way a country can expand investments and capex and overall productivity without, you know, getting bank credit to participate. So that's going to happen for sure.
Now we've been talking about what the road ahead looks like, at a time when markets are at all-time highs, and it would be amiss if we didn't talk about the possibility of a pre-election rally. Now the question over here gets a little complicated because a continuity of the same government has been priced in, you saw that big bump up late last year. Do you think that this has in a sense become a non-event, or are you expecting a bit of a pre-election rally like we have been seeing consistently over the last I would say, five or six general elections three months before the event?
Vinod Kalki: I think we are already in that mode where the market is getting excited that we are going to have a clear mandate. So that rally is already progressing in my view, because if I just wind back six months ago or something around that time, there was some uncertainty about mandate being a little weaker and all but that was, I think, now behind us and people are quite confident that there going to be clear mandate and political reforms are going to continue.
So I think we are already in that kind of situation. That's why the market I think is hooting all-time highs. See, that's already playing out. I don't think there's any huge surprise on that front. Surprise, in the sense, that hasn't played out that you know, the market is taking dominant. That's already underway. as we speak. What can surprise is they see that it's not as clear as it was thought to be, when it actually comes out. That could be the risk.
As of now, there is nothing to suggest that that's going to happen. So I think there could be some excitement post election if it really comes through. But then after that, that will no longer be a trigger. So after that, it's got to be what the final budget will be and what is talked about in terms of a development plan and overall spending and how revenues, picking up all those fundamentals will take over beyond this.
Okay, so you're saying we're already in a pre-election rally. That's what's leading to this excitement and broadly we say okay, because policy continuity etcetera but if I were to ask you specifically, why as an investor or someone who tracks the market, you will think that this will be good for the Indian economy and for investments. Where do you see policy continuity actually make an impact in terms of valuations improving?
Vinod Kalki: If look at the interim, which I thought was just I mean, it should ideally be this statement nothing more but it unveiled one, which I think is undermined, people are not talking much about it, but I think it is very important to note that the interim budget talked about what is called as adding the Anusandhan Innovation as the term into the overall development plan of India long term, which is extremely positive in my view, because when I look at global economies where they spend on innovation R&D, global R&D spend, it's more than 2% or China.
We were at a similar position in China, at the start of the century.... We have just maintained it around 30.7. But there was a lot of emphasis in the interim. budget statement laid out in a corpus of 1 trillion rupees for zero interest rate loans towards R&D spend. I think this is extremely political, in my view, is going to improve productivity in the economy going forward and it is time so well because what you've seen historically is that R&D spend anyways increases when the capex cycle picks up in the economy, which we have seen in the past also.
So we've seen this capex cycle pick up in the economy, private investments happening and if there is a policy measure towards, you know, really pushing R&D spend. That's going to enhance productivity in the economy, and definitely very structured in my view. From a long-term perspective, I am very positive about that.
Let me come to the PSU rally, and you know, you have largely been bullish on PSU companies. Now, we tend to bracket it in one basket, but the fact is that there are many, many different kinds of businesses. You have a PSU in the Energy space and Railways, Banks, etc. Do you think that the overall change in sentiment after decades, that PSU companies can also be profitable, that they can also bring value, will sustain and which of these baskets really look like they will have more to give?
Vinod Kalki: PSU versus Private thing is more to do with how the economy and cycles are playing out. See, if all this positivity from PSUs would never have happened if the PSUs would not have delivered on road driving and the profit sizing. We have seen this story play out. The only thing people have forgotten completely is that between 2003 and 2008 where the structure of the economy was the investment rate capex cycle and you know the companies would grow by balance sheet expansion, they were the darlings of the market.
So when the capex cycle expands, you have balance sheet driven companies really do well because demand for capital intensive sector rises and PSUs are typically in these spaces and they did really well because the profit to growth, the balance sheet expansion, everything was expanding and they did really well during that time.
Post 2012 till about '21 peak Covid, there was a stage when do you want people wait there was this phase of you know that the investment rate, the overall real estate cycle fell, everything fell and the capex cycle fell, corporate capex fell and so that's the time when these companies just did not pick up. But I mean, apart from the cycle, we also see that the emphasis, the focus of the government towards defence spending, defence indigenous manufacturing in India. These are the new initiatives and policy measures which have also helped the overall manufacturing capex theme which is being in companies anyways.
So I think this is phase and as long as the capex cycle continues in my view, such balance sheet driven companies, be it PSUs or private, will continue to do well. The gap between PSUs and private will always remain in my view in terms of valuations, because of the perception that investors typically have, and these perceptions don't change, and they didn't change in the earlier cycle. But what matters is, is growth coming in the sector or not. So, it's clearly coming. We've seen order books of these companies really pick up.
So growth is coming. The PSU and private sort of perception lag will continue but you know, as we round up this conversation and I ask you to look forward, what are the sectors and spaces that you're seeing, with the biggest pop coming ahead, at least in the next six to 12 months?
Vinod Kalki: So, there are two things to answer this. One is there will be continued momentum in some of the sectors. So, where the growth will be good, but there will also be some, for example, banks, you know, they they're getting, what it should say some kind of re-rating is happening. So the combination of these two I think will be where I would bet my money, where the valuations are getting re-rated, and the people are recognising that these valuations are cheap, and the fundamentals are improving to talk about financials and large banks.
On the stock momentum, I'm talking about growth momentum, where the order book is improving and, and demand is robust. I think the mix of industrials, the capex cycle companies and some other discretionary consumption categories like premium products, autos and things like that. I think that these spaces, I will be bullish on. There are large financial banks. Industrial capex driven companies and pockets of discretionary consumption.
