Small, midcap valuations backed by strong earnings growth: Ramesh Mantri

"Sustained FII selling has hurt largecaps disproportionately because foreign investors typically have a higher allocation to these companies"

Even as the artificial intelligence (AI) rally cools, India will need stronger earnings growth to attract foreign capital back to its markets, says Ramesh Mantri, chief investment officer (CIO), WhiteOak Capital AMC. In an interaction with Abhishek Kumar in Mumbai, Mantri adds that the slow earnings growth problem is largely restricted to the largecap space. Edited excerpts:

 

Why are largecaps struggling to keep pace with the broader market? 

Sustained FII (foreign institutional investor) selling has hurt largecaps disproportionately because foreign investors typically have a higher allocation to these companies. At the same time, domestic flows are also weakening as investor interest continues to shift away from largecap-oriented funds. In July, for example, largecap funds saw net outflows, while inflows into small and midcap funds went up sharply. SIP (systematic investment plan) flows are also predominantly finding their way into the small and midcap funds. 

One reason for largecaps remaining out of favour is also weaker earnings growth in several segments. IT (information technology) services, for instance, is facing uncertainty around AI, while growth has slowed. 

Do you see the momentum in smallcaps and midcaps sustaining? 

Investors tend to chase what is working in the market. We saw this with gold and silver earlier and, more recently, with increasing allocations to global markets. In the last three to four months, small and midcaps have generated strong returns, so more flows naturally follow. At some point, investors can overdo this and rebalancing can happen. But I don’t think we are at that stage yet. The important difference this time is that small and midcaps have strong earnings growth supporting their valuations. If largecaps had strong earnings growth, I would say there would be a much greater need to rebalance. 

Sectorally, where do fundamentals and valuations look most favourable? 

The sectors where fundamentals are strong include pharma and healthcare, consumer, banking and financial services, new manufacturing and the power-equipment value chain. These are the areas where we are seeing strong growth. When you overlay valuations, BFSI (banking, financial services, and insurance) and consumer look particularly attractive. Consumer stocks are trading at multi-year lows relative to their historical valuations, while growth has revived. By consumer, I mean the broader basket, including retail, travel, autos, FMCG (fast-moving consumer goods) and other consumer-facing businesses.  Pharma and healthcare continue to have strong fundamentals, although some pockets have become expensive. Manufacturing and power equipment also have strong fundamentals, but valuations have risen significantly, so one needs to be selective there. Largecap IT remains a concern because growth is still weak. Midcap IT is different, with several companies continuing to do well. Energy, oil, gas and metals are difficult to take a fundamental view on because of high macro volatility. Real estate stocks are also not particularly positive. 

Could a recovery in foreign flows help largecaps, particularly if concerns around AI-related investments ease? 

There are two dimensions to this. India was perceived to be vulnerable to AI because IT services are an important part of the economy, while many of the companies benefiting directly from AI are outside India. There has already been some pain in IT services because of AI, so the concern was not entirely misplaced. But the bigger factor for foreign investors is India’s earnings momentum. If earnings growth returns, capital can flow back to India. 

How confident are you that the recent earnings recovery can continue, given the geopolitical and macro risks? 

In the current geopolitical and macro environment, forecasts beyond a point are difficult. But there is reasonable confidence that the earnings trajectory can continue. There are risks, particularly from energy prices, US tariffs and West Asia. India is vulnerable to the West Asia crisis in three ways: Energy costs, the business Indian companies conduct in the region, and remittances from the Indian diaspora. 

Unlike the Ukraine crisis, which was primarily an energy shock for India, the West Asia situation can affect all three areas. 

Are the large number of IPOs draining liquidity from the secondary market? 

I don't subscribe to the idea that IPOs (initial public offerings) permanently suck out liquidity. Capital eventually recycles through the financial system. For instance, when private-equity investors sell, they book profits and eventually raise another fund and redeploy the money. 

Similarly, when promoters sell shares, the money can eventually find its way back into equities, venture capital, private equity or other parts of the capital markets. If IPOs don't happen, exits become difficult, which can eventually reduce the incentive to invest in private markets. 

Your portfolios tend to be fairly diversified. Is that a deliberate strategy? 

Diversification is not the objective by itself. We find many bottom-up opportunities as our large research team is able to cover a wide range of stocks. The portfolio often becomes diversified because there is a limit to how much capital we can deploy in smaller companies. That is a constraint faced by fund managers across the industry.