Next mkt upcycle to be earnings-led, not valuation-driven: Anand Shah

ICICI Prudential AMC's Anand Shah sees manufacturing-led mid and smallcaps sustaining outperformance as earnings growth supports valuations

Mid and smallcap stocks in select sectors such as manufacturing and industrials may continue to outperform largecaps despite higher valuations, says Anand Shah, chief investment officer of PMS and AIF at ICICI Prudential Asset Management Company. In an email interaction with Abhishek Kumar, Shah says higher valuation multiples in select broader market pockets are supported by stronger growth prospects. Edited excerpts:

 

With geopolitical tensions in West Asia easing, what factors will drive equity markets in the coming months? 

Going forward, markets are likely to be driven by corporate earnings, energy prices, and capital flows. Elevated crude oil prices had emerged as a key concern for both India and the global economy. Any moderation in energy costs would ease inflationary pressures and improve sentiment.

 

Another important variable will be relative earnings growth across markets, which largely determines the direction of global capital flows. If India’s earnings outlook strengthens and the currency remains stable, foreign flows could turn more supportive.

 

Which sectors are best positioned to lead market recovery? Conversely, are there sectors where you remain cautious or bearish? 

We continue to prefer manufacturing and allied businesses. Moderate rupee depreciation and a higher inflation environment can improve their competitiveness and profitability. We remain constructive on select private-sector banks, asset managers, and insurance companies. Telecommunications (telecom) is another area where industry consolidation has strengthened the outlook, and tariff increases over time should support profitability. Within consumption, we are relatively underweight on consumer products and prefer consumer services. As incomes rise, incremental spending is moving towards financial services, travel, entertainment, and telecom rather than traditional goods consumption.

 

Broader markets have significantly outperformed since April. Do you see this trend continuing? 

The outperformance of mid and smallcaps has largely been driven by earnings growth. While the Nifty 50 has witnessed relatively slower earnings growth, many companies in the broader market have delivered stronger profit growth. This trend may continue, given the higher representation of manufacturing companies in the broader market. Moderate rupee depreciation and mild inflation could act as tailwinds for manufacturers, supporting earnings growth.

 

How do you assess current market valuations across largecap, midcap, and smallcap segments? 

Valuations across the market are no longer as stretched as they were a few quarters ago. That said, the picture is mixed. Largecaps continue to offer relatively better valuation comfort compared with their historical averages and the broader markets. In contrast, while parts of the mid and smallcap universe continue to trade at relatively higher valuations, they have cooled off from the peaks seen in September 2024.

 

We believe valuations need to be viewed alongside earnings growth. Many mid and smallcap companies, particularly those linked to manufacturing, industrials, and domestic investment themes, are seeing an uptick in earnings growth and return profiles. Therefore, while valuations in certain pockets remain elevated, they are supported by stronger growth prospects.

 

For our portfolios, we are being selective and focusing on businesses where earnings can justify valuations over the medium to long term rather than taking a broad market view.

 

Do current valuations and earnings growth expectations leave enough room for the market to deliver meaningful upside from here? 

The market’s ability to generate returns from current levels depends on earnings improvement rather than valuation expansion. Over the past few years, a significant portion of returns came from rerating. As seen in past choppy markets, and this time as well, earnings growth becomes the primary driver of performance. If earnings growth accelerates towards mid-teen levels over the next few years, markets can continue to deliver reasonable returns. However, returns are likely to be more differentiated across sectors and companies. The environment may reward stock selection and active management more than broad market exposure.

 

What are the key risks that equity markets face at this juncture? 

One of the key risk factors remains inflation, especially if higher energy prices are accompanied by food inflation. Even before the geopolitical tensions, inflationary pressures were expected to rise because of deglobalisation, tariffs, and changes in global trade dynamics.

 

Weather-related risks also warrant attention, as a weak monsoon and rising food prices would be challenging for a consumption-led economy like India.

 

Elevated energy and commodity prices could further worsen inflationary pressures, with higher input costs feeding into sectors ranging from fertiliser and food to chemical and plastic.

 

Persistently high commodity prices could hurt corporate margins, weigh on earnings, and create uncertainty around monetary policy.

 

Foreign institutional investors (FIIs) have turned net buyers after a prolonged period of selling. Do you believe these inflows are sustainable? 

Global capital flows are driven by relative opportunities. In recent quarters, stronger earnings momentum in markets linked to the artificial intelligence theme, such as South Korea and Taiwan, attracted much of the investor interest. If that momentum moderates and India’s earnings outlook improves, capital flows could return to India.

 

Lower energy prices and a stable currency would also help reverse the negative feedback loop between FII selling and rupee depreciation.

 

How should investors balance long-term wealth creation with downside risks, and which segments offer the most attractive risk/reward? 

Investors should avoid making portfolio decisions based on short-term events and instead focus on a portfolio of businesses that can compound earnings over long periods. The most effective way to manage downside risk is through diversification, disciplined asset allocation, and investing in companies with well-capitalised balance sheets, sustainable competitive advantages, and prudent capital allocation.