Valuations no more a concern for mid- and small-caps: Anoop Bhaskar

The correction in the broader market has hurt investor sentiment. While there are challenges, Anoop Bhaskar, head of equity at IDFC Mutual Fund, tells Jash Kriplani that the environment is conducive to looking for opportunities in the mid- and the small-cap segments. Edited excerpts:

1. What indicators suggest that the broader market can do well and that market breadth will not be limited to a few blue chips?

The broader market recovery will depend on two factors. One is broadening of earnings growth, and the other is broadening of flows. One of the factors contributing to a narrow market breadth is the fact that flows coming from Employees Provident Fund Organisation are concentrated towards Nifty50 stocks. When we look at two-year rolling returns of the Nifty, it is somewhere around 12 per cent. Meanwhile, the Nifty Smallcap 100 has delivered negative returns of 32 per cent. The difference between the Nifty and the smallcap index returns is the widest-ever. So, we expect this gap to narrow down as small-caps try to catch-up with the Nifty. 

 2. What factors could lead to a recovery in mid- and small-caps?

The macro-environment seems favourable for mid- and small-cap companies. Interest rates are on a downward trajectory. The rupee is stable and inflation is on the lower side. The only missing piece is domestic flows, which have shrunk. However, earnings visibility will decide which stocks get rewarded and attract investor flows. Due to the correction in prices, valuations are not a major concern. The discount between small-caps, i.e. bottom 250 stocks of the BSE 500, and large-caps is close to the 2013 levels. Over the last six-seven years, even after excluding loss-making companies, the index-level earnings per share has not moved anywhere for small-caps. 

3. Which sectors do you expect to recover sooner than others?

Overall, we expect corporate banks to lead the earnings recovery. Then we can see some recovery in auto and pharma. Last, we could see the telecom sector recover, where the entire industry’s profit pool has deteriorated. Auto and auto ancillary is another sector where profits have come off and the September quarter will probably be the worst for the entire sector. There has been a significant erosion of profits from a three-year perspective. The third is pharma where from 2014-peak till now, because of US FDA and pricing norms, there has been a sharp erosion in profits. So, these are the sectors where there should be the biggest repair in terms of profitability. Corporate banks, including PSU banks, also fall in this category. The recovery will be led by corporate banks as the provisioning has already come down. 

4. What is the outlook on interest rates? Mid and small-cap stocks tend to do well when rates are low...

Banks are not lending. The cut in interest rates is likely to help bond investors, but not companies. For mid-sized companies, the cost of capital continues to remain high. The problem is that the second-tier public sector banks are not growing their books. This has been hurting these companies, which were heavily counting on such banks. To compound the matters, non-banking financial companies — which ended up filling the funding gaps left by PSU banks — have been facing their own liquidity constraints. At the same time, goods and services tax has also added to the working capital requirement for some of these companies. 

5. What is your view of the auto sector? 

 The new product cycle has slowed down considerably. To some extent, Ola’s and Uber’s growth had contributed to demand growth. Around 8-12 per cent of the sales came through this channel. At its recent peak, almost 400,000 cars were getting sold annually. However, we have come down to 100,000 car sales in 2019. The silver lining is that we can't drop significantly lower than these levels. Apart from this, there are new launches lined-up. Also, most players will be launching BSVI models.  Growth of commercial vehicles (CVs) is closely linked to economic growth and infra spending. Between 2017 and 2018, the value of government tender orders averaged at Rs 50,000 crore-Rs 55,000 crore on a monthly basis. This has fallen to Rs 10,000 crore. So, spending needs to pick up for CV recovery.

6. What are the potential headwinds to a broader market recovery?

Most of the risks could be global. If China initiates a currency war, it can have an adverse outcome for the rupee. Mid- and small-sized companies tend to do well when the rupee is steady to strong. When the rupee depreciates, it tends to hurt them. The other issue is that of the three major export regions for India – the US, Europe and Japan — the last two are not seeing healthy growth. They don’t have  the kind of growth rate for our exports to be absorbed. There may be pockets of growth in South America and southeast Asia, but we don’t have access to their growth rates as we don't export to these regions.