Correction in mid and small cap stocks not yet complete, says Kotak Institutional Equities

• Large-cap stocks offer a better reward-risk balance, as they have more reasonable valuations compared to the lofty valuations of most mid and small cap stocks.
• Valuations of Nifty50 are far more reasonable at 17.5 times FY25 earnings against the pricey small and midcap stocks.
• A sharper slowdown than anticipated is a real risk to the consumption and investment sectors.
  

The recent correction in stock prices may not be the end of the downward trend for mid and small cap stocks, according to a strategy report by Kotak Institutional Equities. The report suggests that the correction seen so far is not significant enough considering the rally these stocks have experienced over the past few months.

The report highlights that while there has been a meaningful price correction in Indian equities, the degree of correction has varied across market caps and sectors. In particular, mid and small cap stocks have seen sharp declines, but the correction in their prices is relatively small compared to the rally they have witnessed in recent months.

Kotak's analysis indicates that most mid and small cap stocks in their coverage universe do not offer value, considering the extent of rerating in multiples seen in the past year. According to KIE, “We do not find value in most mid- and small-cap. stocks in our coverage universe given the extent of rerating in multiples seen in the past 9-12 months despite weakening business models and eroding business moats.”

On the other hand, the report suggests that large-cap stocks offer a better reward-risk balance, as they have more reasonable valuations compared to the lofty valuations of most mid and small cap stocks. The Nifty50 Index, for example, is found to have more reasonable valuations at 17.5 times FY2025E earnings per share (EPS), considering the moderate earnings growth and muted performance of the broader market in recent years.

The report also highlights concerns in the consumption sector, where rich valuations do not factor in weak demand in the near term and weakening business models in the medium term. Weak volume growth in 2QFY24 and the broad-based weakness in consumption are attributed to weak growth in quality jobs and high inflation in consumer products over the past few years.

In the investment sector, stocks have performed well on expectations of a strong recovery in the domestic capex cycle. However, the report notes two risks with this narrative. Firstly, there is a possibility of front-loading of government capex in FY2024, which may not be sustainable in the long run. Secondly, financing of capital expenditure through large fiscal deficits may also pose sustainability concerns.

The report also provides insights into the 2QFY24 results, which have been broadly in line with expectations on an aggregate basis. However, there has been wide dispersion in reported performance versus expectations, with banks outperforming while companies in the auto, construction materials, metals, and IT services sectors have missed estimates.

Based on their analysis, Kotak has made minor changes to their recommended large-cap portfolio. SRF has been removed from the model portfolio due to near-term downside risks to revenues and earnings. The weight has been reallocated to HDFC Bank, ICICI Bank, and RIL. While SRF appears reasonably valued, there are growing risks to earnings due to a potential global slowdown and a prolonged slump in global demand for chemicals.

Large-cap stocks are seen as offering a better reward-risk balance with more reasonable valuations. Kotak also highlights concerns in the consumption and investment sectors, as well as the need for caution in stock selection and portfolio allocation.

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