Don't fret over the index valuations and take stock-specific calls

The Nifty Smallcap 250 Index is up 54.8 per cent while the Nifty Midcap 150 Index has run up 49.3 per cent over the past year. Both indexes have surpassed the Nifty 50, which has gained 19.4 per cent.

Amid rising valuation concerns, many retail investors, especially new entrants, have turned jittery and decided to sell equities and go into cash. Others have decided not to deploy money until the market corrects.

Meanwhile, news reports suggest the Securities and Exchange Board of India (Sebi) is in discussions with the mutual fund industry to carry out a comprehensive stress test of equity funds.

Pay heed to earnings prospects

Direct investors shouldn’t sell when the indexes are trading at the higher end of their historical price-to-earnings (P/E) band. “Remember that the denominator, which is earnings, is not stable,” says Jatin Khemani,  managing partner and chief investment officer, Stalwart Investment Advisors LLP, a New Delhi-based Sebi-registered Portfolio Management Services firm.

A lower entry P/E does lead to a higher margin of safety and better returns. “However, the majority of value creation and returns over the next 5-10 years will be driven by stability and multiplication of earnings,” adds Khemani.

Adopt bottom-up perspective

Focus on the valuations of stocks within your portfolio, and not the index. “The key is to judge the stability and quality of earnings, and growth potential. The former comes via an understanding of the business model (economic moat) and the latter via the size of the market opportunity and promoter hunger,” says Khemani.

So long as you hold quality companies with an enduring competitive advantage and sound earnings growth prospects (more than 15 per cent annually), you need not worry.

Don’t fret about correction

A 10-20 per cent correction can happen anytime, irrespective of valuation levels. “If you have a well-constructed portfolio, the drawdown will be temporary. Focus instead on avoiding permanent loss of capital due to faulty selection of business or management, or losing valuation discipline and paying excessively,” says Khemani.   

Avoid complete exit

A complete exit from smaller stocks is inadvisable. “The Indian economy’s prospects remain sound. Many Indian companies have an opportunity to globalise their businesses against the backdrop of global corporations’ compulsion to de-risk away from certain geographies. Many small caps will exhibit significantly higher growth than their larger peers,” says Sandeep Daga, managing director and chief investment officer, Nine Rivers Capital, which offers portfolio management services.

Some stocks are still trading at reasonable valuations. “Select small and midcap companies are still available at reasonable valuations—though not necessarily on historical earnings multiple basis—as many have a robust growth outlook with margin kickers that are not factored in yet.” 

Khemani says diversifying across market caps and sectors may help investors find investment opportunities even in the current market.

Avoid overpaying. “If a stock is expensive even after factoring in FY24-25 earnings, then wait for a more opportune time to enter,” says Daga. 

It is okay to hold some cash. “If you can’t find an opportunity that meets your investment criteria at a reasonable valuation, you can sit on cash until you find one,” says Khemani.

Think twice before selling a quality company. “Selling a good small-cap company when it is on a high growth trajectory is not recommended as one may not be able to build conviction to buy it again even after it corrects. But it is an individual call based on the investment horizon,” says Daga.

Use the rally to rid your portfolio of junk stocks. “Stocks that have relatively weak fundamentals or balance sheet level fragility, but have run up amid the current momentum, may be sold,” says Daga.

Finally, avoid the market’s frothy pockets.  

MF investors must rebalance

Mid and smallcap fund investors should not exit entirely but rebalance their portfolios, especially if they haven't done so in the last 12-24 months, by selling a portion of these holdings. “After rebalancing, continue with your systematic investment plans in these funds. And do not blindly chase returns in this space but build a diversified portfolio,” says Arnav Pandya, founder Moneyedischool.