Largecap stocks’ recovery depends on the revival of foreign investor flows and sustained earnings growth, says Vinay Paharia, chief investment officer of PGIM India AMC. Paharia, in an email interview with Abhishek Kumar, says that while valuations in largecaps have become attractive after a phase of correction, excesses in low-quality mid and smallcap stocks pose a key risk for the market. Edited excerpts:
The market has rebounded from its March lows, but remains below its record highs despite easing macro headwinds and uncertainty. What is holding back the recovery, especially in largecaps?
Largecaps do remain the most attractive segment of the market, mainly because valuations have become a lot attractive now, both on an absolute and relative basis. Earnings are ramping up while stock prices have gone through a phase of time correction. Unlike bonds, equities are a non-linear asset class where actual returns can remain disjointed from earnings for extended periods. However, it has been observed that over a medium to long term, returns from equities follow the underlying earnings growth. The valuation correction in largecaps may be a result of the indiscriminate foreign institutional investor selling we have witnessed in the markets over the last couple of years. Thus, a catalyst for a recovery may also be a return of foreign investors, or domestic money moving into largecaps.
What factors are likely to drive equity markets in the coming months?
A peaceful global geopolitical environment, continued earnings growth supported by a revival in consumer demand in India, continued lower interest rates and revival in flows from foreign investors. India is also considered a contra Artificial Intelligence (AI) trade. Thus, some sanity check on the growth and proliferation of AI could also improve the appeal for Indian markets.
Which sectors are best positioned to do well? Are there any sectors where you remain cautious?
We are positive on private sector banks, health care services, telecom and the consumer discretionary segment of the market. Private sector banks trade at exceptionally cheap, broken-down valuations and are best positioned to capture the potential growth in corporate and consumer credit, enabling them to outpace nominal gross domestic product (GDP) growth in the medium to long term.
Sectors where we are underweight include information technology (IT), energy and commodities. While we have been meaningfully underweight IT for more than a year now, we have incrementally reduced our underweight [position] a little bit as valuations are now turning attractive.
What key risks do equity markets face at this juncture?
Many companies in the small and midcap segment of the market are vulnerable, due to valuation or cyclical reasons. In our recent study, we have highlighted how junk companies (defined by low return on equity or high debt to equity or poor cash flows) have delivered market-beating returns in the last few years, a phenomenon which has seldom happened in Indian markets before the pandemic.
Thus, we are most worried about valuation excesses in the low-quality or low-growth part of the markets, making it the Achilles’ heel of the markets in current times. The market has simply bid up cyclical commodity-oriented businesses, whose temporary spikes in profitability may quickly reverse when the business environment corrects. We want to caution investors to avoid this junk bubble. In fact, optimistic investors can find clear opportunities in investment-grade midcaps and smallcaps.
Broader markets have outperformed since April. Do you expect this trend to continue?
Valuations for small and midcaps have run up ahead of their fundamentals in many segments. This is driven in part by the relentless domestic fund inflows in these segments. While we expect muted performance from this segment in the near term, there are segments like investment-grade companies that are attractive. I would expect the junk-grade segment of the market to materially underperform over the medium to long term.
 "Valuation excesses in low-quality stocks pose biggest risk: Vinay Paharia")
