Midcap stocks seem overvalued, caution is warranted: Gautam Roy

Q&A with vice president and fund manager, Motilal Oswal AMC

After continued outperformance over the last two years, valuations of mid- and small-cap indices have become more expensive than large caps, says Gautam Roy, vice president and fund manager, Motilal Oswal AMC.

Roy, whose MOSt Focused Multi-cap 35 delivered market-beating performance of 15% in 2015, tells Samie Modak market performance this year will hinge on revival in corporate earnings amid weak global sentiment. Edited excerpts:

What is your assessment for the market’s weak performance in 2015?

The most important factor behind the weak returns from Indian markets in 2015 was the drastic slowdown of foreign flows in the second half. Continued decline in earnings for the entire year was another negative factor. While major macro parameters like crude prices, inflation, rates and fiscal deficit improved, the positive impact in terms of a growth revival has only been felt in a few pockets so far. 2015 started with a lot of expectations on the domestic policy reforms front- and ended with very little of the same due to disappointments along the way.

Mid- and small-caps have outperformed benchmarks since 2014. Have valuations differentials between the two now changed. Is that a concern?

Mid & small cap valuations have continued to trend higher, relative to large caps, throughout 2015. Mid-caps tend to have superior growth opportunities in environments where growth rates are on an uptick. They also tend to have higher financing cost burden relative to operating earnings, and hence are bigger beneficiaries of reducing interest rates. The valuation re-rating of midcaps is now pricing in most of the benefits from expected uptick in growth and lower rates. Although not the case for the entire set, select midcap stocks seem overvalued and hence a degree of caution is warranted in buying midcaps.

What is the outlook for 2016? Is there scope for PE expansion given the drying of overseas flows?

2016 should see the indices' movement being driven primarily by earnings trajectory. While earnings has not been growing in the past year, a turnaround, albeit a modest one, looks to be feasible in 2016. A low base in index earnings and in commodity prices should help. A broad-based recovery in demand aided by lower inflation, governmental stimulus or better monsoons will allow earnings to grow at a fast pace.

What are the key headwinds?

Going into 2016, weak global equity flows remain the key headwind. Weak earnings is too--- continued negative surprise in the same will keep markets subdued. Continued stalemate in the parliament's functioning would have an adverse impact on key policy formulation.

What are the key positives for the market?

Stronger macro environment in terms of inflation at long time lows, lower interest rates, cheaper crude and other key raw materials is making the fiscal situation much better at the government, corporate and household levels. We believe this will eventually stimulate demand and financial savings' growth. This is already happening in pockets but a more broad-based recovery will aid the markets.

FII flows were tepid in 2015 but domestic flows were strong. Do you expect the trend to continue?

Given that domestic flows are being driven by lower interest rates and investor interest shifting from physical savings to financial ones in a lower inflation regime, positive domestic inflows should sustain. FII flows will be a function of US monetary policy trajectory and outlook for emerging markets. Both these factors are not supportive yet. India should continue to get higher share of the reduced pie of global flows, given the size of the economy and the fact that growth rates are higher here.