Last week saw a lot of cheer with the Nifty 50 crossing the 20,000 mark, and reaching all-time highs. But the real action has been on in the mid and small cap names. Since April 1, 2023, while the Nifty 50 is up 16%, mid and small caps have been up by 34% and 38% respectively.
Of course record levels are bound to raise some questions on what’s next. And here are some of our observations (not advice):
Are current valuations too high?
While the Nifty 50 is at record highs, valuations aren’t. At current levels, the Nifty 50 is trading at a one-year forward PE of 19x, which is at a 10% discount to its own long period average.
India’s valuations are at a record premium compared to other emerging markets. However, that too seems to be justified given the fact that India is expected to be the fastest growing large economy in the world.
What are the risks at current levels?
Irregular rainfall this season may result in inflation sustaining at higher levels for a little longer. For August, inflation did ease to 6.8%, compared to 7.4% in July. However, this is the fourth instance of inflation being higher than RBI’s tolerance band of 6%.
While the domestic inflation situation may result in an extension of the pause on rate hikes by the RBI, the spoiler to the party can be crude oil. Prices are up 15% since June 2023, and are at a 10-month high, due to supply cuts. India doesn’t deal very well with oil prices going up.
What about mid and small caps?
Mid and small caps had underperformed relative to the large caps over the last couple of years. However, they have caught up and gone beyond what the large caps had to offer, in just under six months.
At current levels, risks seem to be elevated is multiple stocks given very steep valuations, which seem to be driven by liquidity, and exorbitant expectations. That said, there are a lot of stocks with strong visibility and reasonable valuations - a confluence we actively seek and stick on to.
Is this a repeat of October 2021?
Although valuation-anxiety is high again, the situation is different compared to what was in October 2021. That time was shaded by a fresh conflict between Russia and Ukraine, sky-high inflation, and saw the commencement of the steepest and fastest rate hike cycle globally.
Against that, we’re in a phase where inflation is coming under control, regressive monetary policy is retracting, and growth is bouncing back up, amid structurally favourable policy frameworks. Sustenance of highs has a higher chance now, versus earlier.
There are multiple places, especially in the mid and small cap space, where valuations are exorbitantly high. In some cases, stock prices have been factoring in absurd fundamentals, which are next to impossible to achieve. In these cases, we see prices correcting to match up with fundamentals at some point.
However, there are are ample pockets where upside potential exists. We believe this is a time for bottom-up selection; our preference lies towards stocks with demonstrated capabilities, growth visibility, prudent capital allocation, good corporate governance, and reasonable valuations.