Money to flow up the value chain

As the market keeps moving up, over a period of five to 10 years, the ownership of Indian investors in the market should rise a lot more

Money to flow up the value chain
Indian stock markets have been on an upward trajectory that has pushed indices close to their all-time highs. We are now reaching a point where an improvement in corporate earnings looks imminent over the next few years. We are also in a very interesting scenario as far as interest rates are concerned. In our opinion, interest rates may stay down for a while and are unlikely to move up significantly from here. That combination is always very important when we are looking at how valuations will behave and how the markets are likely to move. Hence, it resonates well with our pretty bullish view on equities as an asset class in the longer term.

If one looks at large cap stocks in the index, they are not very expensive considering their long-term averages from a pure valuation perspective. As you go down the chain in market cap, stocks are looking more and more expensive but in the large cap space, there are still a lot of opportunities where valuations are quite reasonable, especially in the context of much lower and stable interest rates. Hence we still stay the course on the long term view on the asset class. Minor corrections can keep happening but the bigger call and the bigger picture is that equities still look like a favourable risk reward.

Rally may be broad-based
The rally in indices would be broad-based for the simple reason that we are beginning to see flows coming back into emerging markets as a category. There may be a slight value tilt to some of those flows incrementally as time passes, but it will be spread across the range of sectors in our opinion.  So when we are seeing a broader uplift across the asset class globally, we are seeing something similar happening here and through a sequence of rotation, there are a variety of sectors that would come into focus. While the low interest rate environment will tend to push valuations up across the board, financials obviously will be an important part of it, given their weight in the index. So that will continue to be the core around which the index would tend to perform.

Small cap party may be winding down
You need the market to be doing well for domestic flows to come in. There is no doubt about the fact that there is very large potential for domestic flows to come into equities, but over the past few years we have seen that a large part of those flows have actually been more focussed on mid to smaller sized companies, and not so much the large caps. People tend to feel more positive on the markets when the mid and small cap companies are doing well rather than just the large cap companies, at least domestically. We would like to see that expand to the large caps because in the mid and small caps, there has already been a fair amount of valuation play so far. It is very stock specific at the moment but the general tailwind on valuations by virtue of companies just being smaller is pretty much complete and is unlikely to repeat itself over the next few years. To reiterate, it is very important that the market keeps moving up for people to derive more comfort and keep allocating more but there is no denying the fact that over maybe 5-10-year period, the ownership of Indian investors in the market should probably rise a lot more from where it is today.

There will always be opportunities, but the strike rate is a lot lower as you go lower down the chain. It is not easy to consistently find smaller sized companies becoming larger and larger. Over time, a lot of them fall by the wayside as well.

One interesting spot that we tend to look at is companies in the 100 to 300 range of market cap, which are outside of the top 100 but are already well established. Companies that have a good track record, have a base amount of profitability, have good corporate structures and governance, and if their business cycle is looking good, there is a much higher probability of them becoming a large cap sooner. That is a spot that we tend to prefer at times like these rather than going too far down the chain.

We recently shut our micro cap fund for fresh flows, largely because the size of the fund itself from a liquidity standpoint makes it very difficult to keep finding incremental ideas. We also wanted to temper down expectations a little bit given the way the fund size itself was growing. This one had done very well in the last three years. It is difficult to replicate that level of performance. So we just felt it was a good time to consolidate this, given all the valuation points. However, there will always be some ideas. India never runs out of entrepreneurship and it constantly amazes us in terms of newer ideas that keep coming up.

Wholesale private sectorbanks may shine
If one looks at sectors overall, one of the underperforming sectors that we like right now are pharmaceuticals. We do not see FDA issues being prolonged. The pharma sector has had a couple of tough years and we are hoping that they will get sorted out gradually. Financial services have been a steady performer right through and that continues to be the largest weight in most portfolios. While that is a space that will keep steadily performing, within that it might be time to start looking at some of the wholesale banks in the private sector. That is an area that we are beginning to look at closely. They have been big underperformers for many years now. So that could be an interesting part of the market to look at because over the next one year, we have reached a point where incremental asset deterioration would be very limited and over the next year hopefully a lot of further recognition will come through. Auto component companies also look interesting and along with textiles, speciality chemicals and agro commodity stocks are some smaller sectors that could do well going forward.

(The author is Executive Vice President and Head of Equities and Strategy at DSP BlackRock Mutual Fund)

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