Mid- and small-cap stocks' risk-reward profile more attractive currently

Market rally could become more broad-based

The benchmark large-cap index (Nifty 50 Index) set another new all-time high recently.  However, investors looking either at their direct equity portfolios or equity fund-based portfolios are likely to see not only underperformance vis-à-vis the benchmark, but also the possibility of negative returns. The key factor responsible for this divergence in performance is the lack of market diversity or the narrowness of the equity rally.

The three data points offered below validate the lack of market diversity in equity performance:

Weak market breadth: A look at the performance of the stocks constituting the four primary indices — Nifty 50, Nifty Midcap 100, Nifty Smallcap 100, and NSE 500 —from the end of January 2018 (previous peak for most indices) till the end of March 2019 shows that market breadth has been extremely weak. In case of the broader market indices — NSE 500, Nifty Midcap 100 and Nifty Smallcap 100 —over 70 per cent of the constituent stocks have posted negative returns during this period. Even in the case of the Nifty 50 index, the percentage of stocks posting negative returns is above 50.

Significant outperformance of large-cap index: A look at the trailing one-year performance differential of the Nifty 50 index vis-à-vis the Nifty Midcap 100, Nifty Smallcap 100 and NSE 500 Index shows sharp outperformance by large-cap equities to the tune of 19, 29 and 7 percentage points respectively.
 

Large-cap index outperformance driven by just a few stocks: A look at the six-month performance of Nifty 50 stocks that are outperforming the Nifty 50 Index shows that since the second half of FY18, the Nifty 50 index’s performance is highly concentrated in just a few stocks, with less than 20 stocks outperforming the Nifty 50 Index.
 

The question is, is the narrowness of the market rally set to reverse? The likelihood of such a reversal is high owing to a variety of factors.

Sharp performance divergence compared to history: This suggests there is a strong potential for reversal. The market breadth and the concentration of performance in just a few stocks have never been so stark over the past 10 years. In addition, the historical differential of the trailing one-year returns (since 2005) between the Nifty 50 Index on the one hand and the Nifty Midcap 100 index, Nifty Smallcap 100 Index and NSE 500 Index on the other, is at peak levels. All the above parameters indicate the potential for a reversal in the spread.

Macro fundamentals supportive of broader market outperformance: Growth indicators are stabilising. Incremental fiscal and monetary stimulus amid easing of liquidity conditions is likely to boost economic growth. This will support outperformance by broader equity indexes relative to large-cap equities. This is in contrast to what we witnessed in 2018, when a rally in crude oil prices, coupled with the worsening of India’s twin deficits amid tighter financial and liquidity conditions, put pressure on the Indian rupee and bond yields. Hence, investors preferred the relative safety of large-cap equities.

Greater valuation comfort: Mid-cap and small-cap equities had a stellar run in 2017, with the Nifty Midcap 100 Index and the Nifty Smallcap 100 Index delivering 47 and 57 per cent return respectively, compared to 27 per cent for the Nifty 50 Index. The valuation premium (12-month forward P/E) of mid-cap and small-cap equities to large-cap equities was at 43 per cent, compared to a 10-year average historical discount of 3 per cent. After the correction we have witnessed over the past year, the relative P/E valuation is now at a discount of 16 per cent, providing an attractive entry point into mid-cap and small-cap equities.

Improving earnings outlook: The Nifty 50 Index’s 12-month trailing earnings per share (EPS) growth has turned negative over the past two quarter (-7 per cent currently), compared to a high of 15 per cent in December 2017. For the Nifty Midcap 100 Index, the same figure has improved to +10 per cent currently, compared to -15 per cent in December 2017. FY20 consensus earnings growth expectations for the Nifty stands at 25 per cent. The same for midcap is 26 per cent. Both are achievable, in our view.

What should investors do: Coordinated policy easing by the government (FY20 budget stimulus plans of about Rs 1 trillion) and the Reserve Bank of India (50 basis points rate cuts in 2019 year-to-date and the likelihood of more, in our view) amid strong foreign investor inflows has boosted equity sentiment. The elections are a key event risk with significant volatility likely, as the outcome can diverge from expectations. But the fundamentals are supportive for performance by equities as an asset class amid robust domestic growth outlook, improving earnings and strong foreign investor inflows.
 

From an asset allocation perspective, given the above positive fundamental backdrop for equities, investors should continue to hold on to their respective equity allocations. Market volatility around elections can be used as a tactical opportunity to deploy into equities if it is under-owned in your portfolio.
 

Investors can also look at diversifying their equity exposure beyond large-caps. At present, mid-cap and small-cap equities offer better risk-reward compared to large-cap equities. Further, the likely improvement in market breadth could arrest not only the current underperformance of funds to their benchmarks, but ensure that quality funds start outperforming their peers and the markets in future.
 

Singh is managing director and head, and Joseph is chief investment strategist, Standard Chartered Wealth Management, India