How is the quality of earnings in the mid and smallcap universe? That space generated a lot of wealth for investors in the last 24 months. Does the outlook look similar for the next 24 months?
Over the last few months, one thing which I have been a little worried about has been that lower quality names have started to move up and that is something to be careful about. Many of the companies over the last decade who have not generated even double digit ROEs have started to trade at 2.5, 3.5 times price to book and very high on multiples as well. Clearly one needs to be careful and avoid it.
Then there is another space which has quality names but because of very consolidated holdings, that space has moved to very frothy valuations and a small earnings miss there could lead to derating in that space. So those are the two spaces one should avoid.
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There are enough opportunities in many sectors like financials. Industrial is another sector where there is opportunity as India’s capex cycle has started to pick up. Real estate ancillary is another sector where for the next few years, multi-year demand generation could happen and one needs to be careful on those two extremes.
Rest of the market looks okay. But in the first six months, cash flow generation across corporate India has not been good. Next six months will be a real testimony to whether they are able to correct their working capital requirements. Many of them have seen elongation and finally we believe that with the lag, markets are very smart enough to track the cash flow generation and rerate or derate the companies. Our eyes are more on cash flows rather than P&L at this moment of time.
Valuations are not giving any margin of safety in the smallcap space as of now we speak. We have seen the best of the breadth on the markets for the last 18 months. Markets will become more selective going forward in the next 6 to 12 months. But if one takes a three- to five-year view, India is on a very strong wicket. One should not bet against India and many of the mid and smallcap companies will gallop into largecap space as we move forward. These will be sectors like home improvement, capital goods, industrials, financials and some of the new-age businesses and companies in consumer discretionary space.
When one looks at that part from a three to five years perspective, there will be enough opportunity but in the near term, I will have a word of caution for most of the investors: “Do not extrapolate the last 18 months’ returns into the next 18 months. Please moderate your expectation on the return side otherwise one can get disappointed.”
