'Mid-cap valuations lofty, large caps offer better reward-risk balance'

Over 40 per cent of total equity inflows into mutual funds have been in the mid and small-cap space in the last six months, however, the recent correction in stock prices may not be the end of the downward trend for mid and small-cap stocks, according to a strategy report by Kotak Institutional Equities. 

The report suggests that the correction seen so far is not significant enough considering the rally these stocks have experienced over the past few months.

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The report highlights that while there has been a meaningful price correction in Indian equities, the degree of correction has varied across market caps and sectors. In particular, mid and small-cap stocks have seen sharp declines, but the correction in their prices is relatively small compared to the rally they have witnessed in recent months.

Kotak's analysis indicates that most mid and small-cap stocks in their coverage universe do not offer value, considering the extent of rerating in multiples seen in the past year.

“We do not find value in most mid- and small-cap. stocks in our coverage universe given the extent of rerating in multiples seen in the past 9-12 months despite weakening business models and eroding business moats," it said.

Kotak finds valuations of the Nifty-50 Index to be more reasonable at 17.5X FY2025E EPS in the context of moderate earnings growth and muted performance over the past two years. Kotak expects net profits of the Nifty-50 Index to grow 16% in FY2024 and 12% in FY2025

"However, we find decent value in a few large-cap stocks and the BFSI sector only in light of rich valuations of most stocks in the consumption, investment and outsourcing sectors."
 

"Consumption demand continues to be quite muted as can be seen in weak volume growth in 2QFY24 too. The broad-based weakness in consumption stems from (1) weak growth in quality jobs and (2) high inflation in various consumer products over the past 4-5 years. We note that improvement in profitability has largely driven the profit growth of

consumer companies over the past 3-4 quarters," said the report.

Investment stocks have delivered strong returns over the past 6-12 months on expectations of a strong recovery in the domestic capex cycle. 

"However, we note two risks with this narrative—(1) possible front-loading of government capex in FY2024 and (2) financing of capital expenditure by large fiscal deficits, which may not be sustainable given high fiscal deficit. Private corporate capex appears to be sluggish given  weakening GFCF/GDP, despite strong government and household capex and tepid recovery in sanctioning of long-term loans for projects," the report said.

Based on their analysis, Kotak has made minor changes to their recommended large-cap portfolio. SRF has been removed from the model portfolio due to near-term downside risks to revenues and earnings. The weight has been reallocated to HDFC Bank, ICICI Bank, and RIL.

 While SRF appears reasonably valued, there are growing risks to earnings due to a potential global slowdown and a prolonged slump in global demand for chemicals.