Morgan Stanley bullish on small, midcaps on growth recovery, valuations

Aditya Birla Capital, Jubilant FoodWorks, MhpasiS, Narayana Hrudyalaya, and Tata Power are among the 22 SMIDs where it remains bullish.

A recovery in growth coupled with attractive valuations should see the small-and mid-caps (SMID) outperform their large-cap peers going ahead, wrote Ridham Desai, head of India research, and India equity strategist at Morgan Stanley in an August 18 note with Sheela Rathi. Aditya Birla Capital, Jubilant FoodWorks, MhpasiS, Narayana Hrudyalaya, Sobha Developers, and Tata Power are among the 22 SMIDs where it remains bullish.

“With monetary aggregates normalising and significant policy action underway with a corporate tax cut last September, we think growth is set to turn. Smaller firms are likely to benefit more due to their operating and financial leverage. Small, midcap valuations are looking attractive relative to gross domestic product (GDP) and money supply, setting the stage for outperformance versus large-cap stocks in the coming months,” Desai and Rathi wrote.

These two market segments, Morgan Stanley notes, went into a prolonged phase of underperformance after peaking in early January 2018 and tanked a massive 40 per cent relative to the BSE Sensex between 2017-end and March 2020.

Stretched valuations (SMIDs were trading at 50x trailing earnings in 2017-end, over twice the multiple for S&P BSE Sensex), growth deceleration in the backdrop of policy measures such as implementation of goods and services tax (GST) and demonetisation, Morgan Stanley believes, were among the key reasons for the underperformance of the SMID segment since then. However, they now expect the reversal in relative SMID performance, which began in April 2020 to continue.

“Once the impact of COVID-19 ebbs, the cumulative policy response plus monetary system normalisation should once again bring back growth, in our view. This would benefit the broader market more than large companies since smaller companies have greater operating and financial leverage,” Desai and Rathi said.

That apart, valuations of these two market segments seem attractive.

“Valuations of SMID stocks are looking more attractive, setting them up for a re-rating if the growth outlook improves as we think it will. Relative price-to-book (P/B) is down to 0.75, though ideally this would be lower than its long term average. The considerable profit damage inflicted over the past two years has also depressed book values (compared to larger companies) distorting multiples,” Morgan Stanley said.

Possibility of another lockdown given the rampant spread of Covid-19 in India, lack of structural reforms that could once again polarise the market behaviour in favour of large-caps and the stress in the financial system are the three key risks to the recovery and a sustained rally in the SMIDs, according to Morgan Stanley.