High smallcap valuations, temper return expectations: Kotak MF CIO

Midcap and smallcap companies’ annualised earnings growth is expected to be 8–9 per cent higher than that of largecaps. This outperformance is crucial for their relatively higher valuations to sustain, says HARSHA UPADHYAYA, chief investment officer, equity, Kotak Mutual Fund (MF). In an email interaction with Abhishek Kumar, Upadhyaya says domestic-facing sectors like automotive, cement, and construction are a better bet right now as global uncertainties prevail. Edited excerpts:

Midcaps and smallcaps have outperformed largecaps by a wide margin this year. How have valuation differentials changed?
 

Midcap and smallcap segments have outperformed the largecap segment by over 20 per cent in the past 12 months.

The outperformance has been significant since the pandemic lows as well. Consequently, on a relative basis, midcaps and smallcaps have become more expensive than largecap stocks.

In terms of relative earnings yield, there is currently no margin of safety in midcap and smallcap segments.

Do you expect the tables to turn next year?
 

For higher relative valuations for midcaps and smallcaps to persist, earnings delivery will be crucial going forward. We anticipate an 8–9 per cent higher compound annual growth rate (CAGR) in earnings for midcaps and smallcaps over largecaps in the two years, 2023–24 (FY24) through 2024–25 (FY25), and meeting this expectation is essential for the valuations to sustain.

How does one play the smallcap theme now?
 

Staggered and disciplined investments in diversified smallcap MFs with a long-term orientation are advisable.

Additionally, investors should temper return expectations compared to the recent past and also be mindful of rich valuations, which could result in higher volatility than in the recent past.

What are the earnings growth expectations for FY24 and FY25?
 

We anticipate approximately a 17 per cent CAGR in earnings growth for the National Stock Exchange Nifty basket over FY24 and FY25.

Has valuation comfort emerged for the Nifty after the second-quarter (Q2) performance?
 

In our view, the Nifty basket is trading within a more or less fair range of valuations compared to a long-period average of 18.5 times the one-year forward price-to-earnings multiple.

Recent quarterly earnings also positively surprised by beating market expectations. Undoubtedly, there is more valuation comfort with respect to largecaps.

How will next year’s general elections impact the markets? Do investors need to align their portfolios because of this large event?
 

Investors must maintain adequate asset class diversification and focus on the long term rather than building a portfolio with a view to short-term events.

India’s growth story is robust, and the corporate earnings cycle has turned up quite convincingly. One should concentrate on participating in the long-term growth story of India while managing risk.

If we enter the election phase at even higher valuations, then investors are advised to review their asset allocation.

With the US bond yield starting to ease and US Federal Reserve (Fed) rate-cut hopes building up, do you see foreign portfolio investor flows coming back in a big way?
 

With potential interest rate cuts by the Fed in 2024, we could see increased flows into emerging markets (EMs).

India continues to be one of the preferred investment destinations within EMs, given its superior growth rates and increasing weighting in the EM index.

Inflows into smallcap funds have remained elevated despite concerns around valuations. Is deployment a challenge right now?

We have always been very calibrated in our approach. We do not get swayed by short-term events and always focus on business fundamentals and valuations while constructing portfolios.

Given the currently higher valuations, we have been gradually deploying the money and maintaining a well-diversified portfolio.

Kotak MF has a comparatively higher allocation towards automotive, cement, construction, and capital goods. What is the rationale?
 

The visibility of domestic growth is quite high compared to subdued global growth.

In Q2, the Indian economy grew at 7.6 per cent, and we anticipate this strength to continue.

We expect domestic-facing businesses to continue growing at a better pace in the medium term.

Additionally, we anticipate the above-mentioned sectors to deliver higher-than-average market earnings growth over the next two years.

Also, your take on information technology (IT) and non-banking financial companies (NBFCs) — the two sectors you are underweight on.
 

Global growth continues to be sluggish, which is crucial for IT services growth.

As mentioned earlier, we expect domestic growth to outpace global growth and, therefore, prefer domestic businesses over global-facing ones.

In the case of NBFCs, we have avoided monoline businesses and smaller names as we believe diversified lending businesses can withstand the uncertainties much better.