Mid-cap frenzy driven by irrational exuberance but Nifty50 looks to be on solid ground with RoE set to go past 17%

• Kotak Institutional Equities says there isn’t any meaningful change in fundamentals of mid and small cap stocks.
• Investors are buying into mid-cap stocks across sectors like defence, capital goods, railways, real estate and renewables.
• Return on Equity of Nifty50 universe in contrast is set to go past 17% by FY25, driven by recovery in capex intensive businesses and cyclicals.

Markets are hard to predict and the recent rally has made it even harder for experts to forecast anything. Rakesh Jhunjhunwala, the late maverick investor, often likened markets to women, simply because both are hard to predict. He once famously said: “Markets are like women, always commanding, mysterious, unpredictable and volatile.” He was the perennial bull who believed in the India story just as Kotak Institutional Equities continues to err on the side of caution.

There is a good reason behind such caution. India may be the toast of retail investors, but foreign investors have sold Indian equities in August. Equities clocked 2% gains month on month against the aggregate returns of 5.3% in the calendar year to date. Other emerging markets have declined by -6.4% month-on-month.

Investors may be bullish and capital flows remain strong, but there is no doubt that growth is cooling even in India. India’s nominal GDP growth has also moderated further to 8% year-on-year in the June quarter, from 10.4% in the March quarter, but real GDP growth improved to 7.8% after 6.1% in March. According to Bandhan Mutual Fund, “The market seems to be caught between a constructive medium-term outlook and rising concerns in the near term.”

Kotak Institutional Equities has consistently said that there was no change in the fundamentals that could justify a rally that has broken out in the Indian markets since the middle of this calendar year. In its latest note, KIE has said that the primary reason for the rally in mid and small cap stocks is the irrational exuberance of investors. In its note Kotak Institutional says: “We see limited point in trying to find fundamental reasons behind the steep increase in stock prices of several mid-cap. and small-cap. stocks. There is no meaningful change in the fundamentals of most companies; in fact, they have worsened in many cases.”

There is no fundamental change in the economic or earnings outlook of these mid and small cap companies. If anything it is the investor sentiment that continues to fuel these prices. Data released by the Association of Mutual Funds In India shows that while the large cap funds have seen outflows in the month of August, the mid cap and thematic funds have seen inflows of over Rs 4,000 crore. Analysts say that the huge number of retail investors in these mid and small cap stocks have driven up stock prices to irrational levels.

Interestingly, not all mid and small cap stocks are on fire. Some of the old favourites of institutions in the consumer space are laggards as their earnings have been downgraded on weak consumer sentiment across India, especially in the rural areas. Currently, investors are favouring stocks across sectors like defence, capital goods, railways, real estate and renewables. Kotak also believes that many of the stocks that have run up don’t have very good execution or governance track records.

It depends on the lens that analysts are looking through. While Kotak Institutional Equities quite rightly believes that a lot of the stocks in the mid and small cap category have no real fundamental trigger to rally, there are others that tend to look at the big picture. ICICI Securities expects Nifty50’s return on equity to rise above the 15% mark by FY25. This shift will happen after a decade or more.

The brokerage says “We expect RoE to expand to 17% by FY25, thereby clearly entering the value creation zone, driven by an improving demand environment for capital intensive and cyclical stocks.” A similar cycle was witnessed between 2002-2007 when a cyclical recovery in the economy driven by the capex cycle boosted RoE to over 25% and price/book beyond 5x. The cascading effect is often seen to percolate down to smaller companies as well when there is an overall recovery in capex intensive businesses. It tends to create a virtuous cycle. However, the near-term risks cannot be ignored either.

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