Smallcaps not in extreme bubble territory: IIFL Securities chairman & MD

Smallcap stocks across sectors have consistently exhibited higher earnings growth than largecap stocks over the past two decades. This, to some extent, suggests that we are not in an extreme bubble territory, according to R VENKATARAMAN, chairman and managing director of IIFL Securities. In an email interview with Sundar Sethuraman, Venkataraman observes that markets will also receive support from monetary easing globally. Edited excerpts:

With the significant rally in the markets, there’s a considerable amount of optimism embedded. How do you interpret this? Have the markets become overly exuberant, or does India’s growth potential justify such a valuation premium?
 

The Indian economy is experiencing growth above 7 per cent, and even in the worst-case scenario, it should comfortably remain above 6 per cent in the foreseeable future.

Given the relative stability of the rupee against the dollar, even the gross domestic product (GDP) growth in US dollar terms is expected to be well above 10 per cent, surpassing that of other major economies.

The National Stock Exchange Nifty earnings growth for 2023–24 (FY24) through 2025–26 (FY26), excluding oil, is projected to be above 14 per cent. This provides a robust springboard for future growth. Hence, the seemingly stretched valuations are not inherently excessive. If anything, it is an opportune time to enter the market cycle.

Do you believe mid and smallcaps have become overheated? Several mutual funds have imposed restrictions on inflows into smallcap schemes. Would you advise investors to proceed with caution?
 

Rather than categorising by market capitalisation (mcap), it is more prudent to assess sectors with momentum in relative terms and compare their valuations.

However, in midcaps, particularly, the limitation to 150 stocks and consistent inflows has led to increased valuations and performance. Consequently, this has attracted even more investor flows, and some underperformance might naturally correct the situation.

Interestingly, smallcap stocks across sectors have consistently shown stronger earnings growth than largecaps over the past 20 years. This, to some extent, suggests that we are not in an extreme bubble territory.

Additionally, many public-sector undertakings (PSUs) boast higher return ratios than private companies. For instance, Coal India (CIL) maintains a return on equity (RoE) of 36 per cent.

How do you think one should navigate the market at this juncture? Are there any themes or sectors that present value?
 

Cement, building materials, non-banking financial companies, select automotive, pharmaceutical, and banking all appear promising. Capital goods and steel also present intriguing opportunities.

Conversely, fast-moving consumer goods, several consumer discretionary names, and information technology seem uncertain.

Has the PSU sector seen considerable run-up?
 

PSUs have undergone a rerating, and their average earnings delivery has been impressive. We believe many PSUs still hold considerable value.

In the universe of PSUs with an mcap of $500 million or more, the average mcap is $9 billion, with government holdings at 66 per cent. The price-performance in the past 12 months stands at 151 per cent, the price-to-book ratio is 3.9x, and the enterprise value-to-earnings before interest, tax, depreciation, and amortisation (Ebitda) for 2024–25 (FY25) is 17x.

We identify State Bank of India, CIL, NMDC, Petronet LNG, Gujarat State Petroleum Corporation, and Garden Reach Shipbuilders & Engineers as some of the most attractively priced PSUs.

What are the primary tailwinds for the economy and the markets?
 

RoE has rebounded from the pandemic lows, though there is still some ground to cover to reach previous highs. Both banks and companies have relatively light balance sheets.

Recent protective financial regulations should prevent the buildup of excesses. The economy maintains its impressive growth pace despite limited recent acceleration in private investment and consumption. Political stability is evident, economic reforms are in focus, and there has been robust infrastructure buildout.

Global monetary easing, led by the US, will further support the markets. Falling inflation, aided by soft commodity prices, and a slowdown in global growth are contributing factors. This scenario bodes well for the Indian economy.

In India, we expect a gradual decline in interest rates; we expect the Reserve Bank of India to commence rate cuts immediately after the US Federal Reserve, likely starting in June.

What are the key insights from the October-December quarter (Q3) of FY24 earnings, and will the growth projections for FY24 and FY25 be met?
 

In Q3FY24, a sample of 478 companies from the BSE 500 universe witnessed an aggregate sales/Ebitda/net profit growth of 3 per cent/19 per cent/23 per cent on a year-on-year (Y-o-Y) basis. However, on a quarter-on-quarter (Q-o-Q) basis, Ebitda/profit after tax contracted by about 5 per cent, even as sales grew by 5 per cent. The aggregate Ebitda margin change was 200 basis points (bps) and minus 150 bps on a Y-o-Y and Q-o-Q basis, respectively.

The Nifty50 and Nifty Smallcap indices experienced marginal downgrades to their FY25 earnings estimates, while the Nifty Midcap saw a 6.3 per cent upgrade. We believe that achieving the earnings growth of 14.3 per cent for FY24–FY26 (excluding oil) is eminently feasible.

What is supporting the domestic demand for equities, and will domestic liquidity support persist?
 

Currently, net of redemptions, the inflows (primarily through systematic investment plans) stand at around $20 billion per annum.

Although household financial savings have declined to a low of 5.1 per cent of GDP for 2022–23, this figure is still 10 times the inflow into equities. Consequently, there is a long runway before reaching any steady state.

Do you anticipate that the new paper supply will weigh on market performance?
 

Promoter holding in largecaps, excluding HDFC Bank, has remained constant at 52 per cent over the past three to four years. In mid and smallcaps, it has declined by around 300 bps.

Considering mid and smallcaps have a combined mcap of around $1.2 trillion, one could argue that approximately $12 billion in paper supply occurs annually on average. This amount is less than the domestic inflows alone, indicating that it is not overwhelming.

Furthermore, when global monetary easing initiates, there is expected to be an influx of money into emerging markets.

India, deemed the brightest star based on a mix of economic indicators, appears poised for further market growth.