There has been a 5% reversal in small and midcap stocks and the big question being asked is are we in for a repeat of 2017 and 2018?
No. The reason I say that is because 2017-2018 saw a decline in the progress of the Indian economy. I think the trigger there was the negative inflation in rural India followed by the financial crisis that saw IL&FS and DHFL fiascos. The midcap decline was probably correlated to a downtrend in the Indian economy which continued even as the Covid hit us. Then Covid gave it a further drubbing. Today the situation is opposite. We are on the back of a rebound in the economy.
Post Covid First Wave, we saw some rebound and then the second wave dampened it. Now the vaccination story is improving, the testing is improving and I think even if a third wave comes, the confidence of the economy can tackle it. There is good news on the export front, good news on the PLI investment front and lots of capex announcements. So I think, this is just a bit of profit taking because retail participation has driven this rally and naturally there will be a certain amount of profit booking as they see their money doubling and tripling.
But the underlying story is of an Indian economy in a recovery mode and by next year, we should be full on. There is a low base due to last year, but a sustainable 7% odd real GDP growth augurs very well for the mid and small caps space. I would say a long term investor should look at the correction to actually buy into quality midcaps and that is the differentiation I want to make. There has been a runup in everything and there is a lot of froth. Quality was forgotten in terms of the rally after the end of the first wave.
Now, quality stocks that can benefit from the economic revival and not just on news flows, are the ones which will benefit. So, it is a good time to do selective buying across the mid and small caps. I do not think this correction in the indices is something sustainable because Indian economy is on the mend.
While the template is not 100% right since markets are forward looking. What you are saying may play out, the economy will grow, earnings will come but maybe it is already in the price?
Yes, what happens between what is in the price is the difference between a safety play and a cyclical growth play. In a safety play, you can say that it is in the price and can only expect normal growth rates as the earnings meet expectations.
In the cyclical growth plays, there is past evidence of V-shaped recovery in earnings predicting the recovery in cyclicals. I would say that the earnings will still come and give us an upside. The only difference is the timing. If the market expects it to happen by 2022-2023, it may actually happen by 2023-2024. But if you hang in there on the industrial cyclical belt, when you have something going 12, 10 or 8, market predicts 6; if you you called 8, 10, 12, market predicts 14. But it does not go in a linear line.
Economy sensitive small and midcap stocks have high fixed cost and high interest costs. A 10% increase in the top line will lead to a 20-25% increase in the bottom line. But the market will not take such a strong leap and they will come up with weighted average and put it in between.
So, when you pick a good quality company, it has the ability to invest in capex at the right time, build its order book and deliver. It is a very technical thing. In terms of quality, it is the capability of that company and the organisation to meet the demand surge. If quality stocks are picked, earnings exceeding market expectations is really going to drive them up.
You have given a lot of key drivers behind this rally in mid and small caps. Going forward what shape do you see this market take? Will it continue to be one of those markets where regardless of PE, regardless of valuations, you see a run up in the stock?
The key point here is that when you look at the forward direction of the market, remember that there are two very different segments in the market; one is the established old world companies, some of which are well valued because there is predictability, some of which are cyclical and V-shaped.
In the manufacturing space, by and large things are predictable and the PLI scheme, the infrastructure pipeline, the real estate housing thing is going to drive these stocks forward. But there is another huge segment and that is what I call the emerging India which is largely in the services sector. The services sector is the most informal of all the sectors. About 55% of India’s GDP comes from the services space and why is that not reflected in the stock market?
Even today, the stock market is only reflecting 36% to 37% as a services market cap. So there is a huge 18% gap in the real economy that is driven by services which are not reflecting in the capital markets. What the recent boom has done is it has allowed all these companies to come into the stock market through IPOs.
All the IPOs which are largely in the services space, are coming in for the first time which means that there is no valuation history; there is no methodology to evaluate them; there is no earnings predictability because these are all businesses which start small and scale at 100 times. So the market will be in a discovery phase and that is where retail investors are all entering because they have a close connect with these companies in their day-to-day life. Now they do not know about the stock market, they are new investor;, the whole explosion of demat accounts and retail in India is coming from investors who sense that the internet, the digital world, the easy ordering that is their world and they sense it and they say that company is coming to the stock market I am confident it will do well. He does not care about valuations.
Going forward, this gap between services economy share and services market cap share has to narrow. If a very wide set of IPOs comes in, then the froth can get spread across the lot but definitely the new-age investor is going to invest in companies which he can understand and not in your traditional cyclical kind of bets. That is where one is going to differentiate.
The new IPOs are rising and so to play this market, one has to have a balanced perspective because as a market participant it is not just about your analysis and what you pick, it is also an understanding of what the others are buying and what is likely to then go up. The world including the stock market is changing and an awareness and a balanced approach will pay off.
Do you think that going forward, market leadership will be taken by simple businesses that you and I and the general mass understand like for example Zomato, Swiggy and Paytm. Do you think that is where we will see the next round of market rally?
Yes, you have hit the nail on the head. For a new first time investor, he comes in understanding that that business will succeed. So all of these things where you mentioned Zomatos and Swiggys and Ubers and the Olas and the Oyos are what they know. Go back three decades ago. What was the favourite stock which everybody said that it is a good long term buy ? It was
. Why? Everyone uses toothpaste and knew they were going to use it his entire life. Today this generation is going to see what is simple, what is adding value to his life and coming to the stock market, is investing in it.
So what happens then to classic traditional businesses? The relatively secure, relatively less volatile businesses like large banks, FMCG and metal companies? Do you think that the metal rally will start tapering off?
Not necessarily. The stock market today is a three-way pie. There is an FPI pie. There is a domestic institutional pie which is your LIC, insurance, mutual funds and then there is this retail pie. What I spoke about was the retail pie. FPIs are always going to look at two things – one is how is the world growth, where is India going to benefit. So export plays like IT and pharma and global cyclicals like metals. FPIs will be looking at global trends and then take the Indian companies to buy those. The domestic mutual funds by nature of their existence are going to be diversified. They are going to have a share of everything so they cannot get focussed into one.
It is true that there are focussed mutual funds which can do something like that but by and large this is diversified. Two-thirds of the play — FPIs and domestic institutions — are still going to be buying the broadbased old economy market based on the infrastructure story. The three pillars of infrastructure are the national infrastructure pipeline, the PLI scheme and the housing real estate sector boom. These are structural changes which are going to benefit in terms of actual earnings and the institutions understand this model well and that is where they will put their money. So they will continue to get support and so the rally will not fizzle. In fact, these people will drive those up.
One has to see how retail investors behave if and when there is a correction. How these so called Robinhood investors react is still an unknown commodity. So far they have shown resilience. I hope that sustains and continues but if they panic, then the froth in these new-age IPOs will come down and the old economy, traditional valuation based model will dominate the stock market.
One section of the market may drive this one way but in the overall market, the mix may change a little bit. I would still say our standard fundamental growth at a reasonable price basis is not going to go away and will continue to support the kind of sectors that you spoke about.
Right now if we have to construct the retail investor’s portfolio, what mix would you recommend?
I would say that it should be safety oriented. When I say safety, it is the degree of certainty, of predictability of the earnings stream. So, I would put IT and consumption stocks into that bucket. That is one bucket of investment.
The second bucket is the Indian economy’s revival story which is largely cyclical, industrial and rate sensitive. In consumption, it will be consumer discretionaries, auto, housing and capital goods suppliers.
The third bucket is the new age companies coming in which have no history in the stock market and are coming in through the IPO mode and are presenting exciting opportunities.
For the new age investor, I would suggest a 30-40-30 allocation, 30% on the predictable earnings stream, 40% on the cyclicals going to a V-shape takeoff scheme and another 30% in the simple to understand but new to the capital markets businesses via IPOs or post IPO through the market. So that is the mix for a new age millennial kind of investor that I would recommend at this stage.
What could be the next trigger for markets to go higher?
The next trigger is the continuance of the monsoon and the festival season related demand pickup. Because of the second wave, consumption has been held down and there is pent up demand. That combined with the fact that festival season will see festival bonuses in the eastern side in the Durga Puja, in the western side and the northern trough during Diwali. That will put a lot of money in the peoples’ hands. If data around vaccination progress from a domestic perspective, data around the monsoon progress, data around the third wave’s actual arrival beats the festival season and if we are able to push the third wave beyond the festival season, you will see a massive rise. That will then be a trigger. In terms of timeframe, I would say somewhere between Puja and Diwali is the time for a trigger.
The market will look at these numbers but it is not important just to look domestic. One also has to see on the overseas front how the US numbers look. The Fed is trying to calm the markets and keeps saying that tapering is very far away but the Fed has to be a slave to real data and if the real data surprises on the upside, the Fed will just forget its past speak and say the data looks good, inflation is no longer transient, we see that it is sustainable and they could announce, that is the one trigger which you have to keep in mind in terms of overseas.
There was a trigger around oil a few months back but I think that is easing in the sense of the Iran situation resolution, the OPEC policies and the fact for the US shale guys, the breakeven costs have come down substantially and they can always increase supply. So oil is not as much of a worry as it was a few weeks ago. For me, it is the US growth, inflation framework metrics that one has to keep an eye on.
Diwali is a trigger where the markets could touch new lifetime highs unless of course the risk factors that I have mentioned happen.
