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Market Update: Indian Equities – Preference for Large Caps Amid Cyclical Exuberance in Small and Mid-Caps

Market update
Equities
India
MidCap
Valuation

Market Update: Indian Equities – Preference for Large Caps Amid Cyclical Exuberance in Small and Mid-Caps

Nov 2, 2023

  • This year, the Indian equity market has proven to be one of the best performing stock markets globally. Our overweight call on India equities is working well. We remain comfortable with our bullish India view but are monitoring indicators such as the growth/inflation dynamics, earnings momentum, valuations, and investor flows, before we make any adjustments to our tactical tilts. We maintain our mild overweight on Indian equities but are getting cautious on India’s mid-and small caps sector. Since bottoming in March 2023, MSCI India has gained circa 12 per cent, while MSCI India Midcap and Small cap indices have gone up circa 24 per cent and 30 per cent, respectively
  • While returns for MSCI India have been driven by earnings upgrade (no Price-to-Earnings rerating), the returns of small and midcap stocks have come from sharp PE multiple expansion. Market returns are normally a function of expected earnings growth vs the actual delivered earnings, but in this instance, the small and mid-cap indices seem to have run ahead of themselves. The steep PE multiple rerating in the small and mid-cap Indian equities appears disconnected from their underlying fundamentals, which do not appear to have improved. In fact, fundamentals have deteriorated in many cases - erosion of business moats, lower revenues and profitability, poor execution and governance, being the case in point
  • Most of the conventional Midcap favourites – the consumption stocks - have seen their earnings decline due to weak consumption demand. Others in the ‘investment sector’, while benefiting from the broader ‘investment narrative’, may not be the highest quality stocks, given their poor execution and weak governance structures
  • The primary driver of the steep run-up in small and midcap stocks appears to be sentiment driven exuberance among retail investors, whose purchase decisions are driven by the high return expectations, stemming from the extraordinarily high returns over the last six months. As a result, retail investors have driven large inflows in the mid and small cap mutual funds. But given their patchy fundamentals, we do not think stocks in the small and midcap space offer decent upside potential. Instead, they may see a correction soon once fundamentals catch-up and investor exuberance subsides. We continue to believe in India’s structural growth story with an overweight view on Indian equities, and a preference for quality large caps over the mid and small caps as a risk management exercise

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