Domestic markets have retreated from recent highs, while earnings growth estimates have been revised downwards. Markets are increasingly polarised, said leading money managers during a panel discussion at Business Standard BFSI Insight Summit in Mumbai in November. Small and midcap segments show signs of bubble-like valuation and other segments are more reasonable, they said while discussing ‘Is the Market in a Bubble Zone?’ The panellists were Ashish Gupta, chief investment officer (CIO) of Axis Mutual Fund; Sailesh Raj Bhan, CIO of Equity, Nippon India MF; Anish Tawakley, Co-CIO of Equity, ICICI Prudential MF; Mahesh Patil, CIO of Aditya Birla Sun Life MF; Rajeev Radhakrishnan, CIO - fixed income, SBI MF; and Mahendra Jajoo, CIO - fixed income, Mirae AMC. Edited excerpts:
Various indices are off their highs. Are valuations more compelling now? And now, will the new administration in the US impact markets?
Gupta: After nearly 3-4 years of strong performance, the market corrected by about 7 per cent in October. However, I wouldn’t say that the valuation excesses have fully dissipated. One of the key factors behind this correction, aside from foreign money outflows, was the disappointing earnings season for the September 2024 quarter. Nearly 45 per cent of companies missed their earnings expectations, leading to downward earnings revisions.
As a result, even with the market’s recent pullback, it hasn’t become significantly cheaper on a simple price-to-earnings basis, as earnings have also declined. Therefore, valuation comfort hasn’t yet returned. I wouldn’t generalise across the entire market— there are still pockets of good value, while others remain in what could be described as the ‘bubble zone.’
The policy direction in the US will become clearer in the coming months, but based on campaign announcements, one trend is evident: Rising fiscal deficit and inflationary pressures are likely to persist. Markets have already started factoring in these expectations over the past two months. This is reflected in rising US bond yields, even as the Federal Reserve has cut rates.
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Patil: A bubble occurs when everything — sentiment, liquidity inflows, valuations, and economic cycles — reaches its peak. While pockets of the market exhibit such traits, the broader Nifty valuation today is similar to pre-Covid levels, which were not in bubble territory. The strong earnings growth momentum over the past three years has supported these valuations, though this year, the growth rate is slowing down from around 20 per cent compound annual growth rate (CAGR) to single digits.
The growth we’ve seen in the market, especially on the Nifty, has largely been driven by earnings. Indian markets have traditionally been seen as expensive due to the country’s relative growth prospects, which still appear solid compared to other global economies. Indian companies still boast superior profitability and return on equity (RoE). This suggests that valuations may justifiably remain slightly higher. Moreover, macroeconomic stability is much stronger than it was five years ago, particularly in terms of the current account deficit and rupee volatility. Post-election, US growth may improve and compete with India. On the Nifty and largecap, valuations seem fair, but there has been a significant rally and euphoria in the small and midcap spaces, where a lot of money has flowed in. Investors should exercise caution, as slowing earnings momentum coupled with lofty valuations could pose risks in these segments.
Investing in smallcaps has been the flavour of the season. But valuations there are high compared to their long-term averages. Can we say they are in a ‘bubble zone’?
Tawakley: A market being just 10 per cent overvalued doesn’t necessarily constitute a bubble. However, in the small and midcap spaces, there are many companies where risks have been overlooked, and investors haven’t fully realised that these companies aren’t as solid as they appear. Those are the companies that are in bubble territory. It’s important to be mindful of several factors. In India, even corporate governance can be cyclical. A lot of these companies are raising capital, which raises a red flag. When people ask me why foreign portfolio investors (FPIs) are pulling out, my response is: Why are so many promoters selling or diluting their stakes?
That’s the more relevant question. This situation will likely lead to an adjustment in valuations, and many companies that are currently offering overly optimistic guidance will eventually fade into the background. Investors need to be particularly cautious in the small and midcap spaces.
If promoters’ selling is a red flag, why do we often see MFs as counterparties in many of the block deals? So, how does one read that situation?
Tawakley: I have managed a smallcap fund for about a year and a half and the largecap for much longer. I have stayed away from a lot of these, but people who have handled that successfully can answer it better than me.
Bhan: The trouble with bubbles is that you only realise you’re in one after it bursts. Right now, while certain segments of the market are fairly priced, nothing can truly be considered cheap. The real challenge may lie in investor sentiment. Many investors are entering the market with unrealistic return expectations. If you look at mutual fund flows over the past 6-9 months, a large portion of the money has gone into sector funds that have performed well in recent years.
The challenge is clear: There’s an undeniable euphoria in the market, and it continues to drive investment decisions. This is typical of markets — when more money chases fewer opportunities, valuations become distorted.
Another key issue is promoter selling. Promoters are finding their own companies’ valuations so high that they’re looking to reduce their holdings. What's more concerning is that many of them are reinvesting the proceeds into mutual funds, diversifying away from their own companies.
We have to be extremely selective in the companies we invest in. Our guiding principle is simple: If you can’t afford to buy a company at 15-20 per cent lower than its current price — because its business model seems unstable — then that’s a company you should avoid. These are not stocks to chase right now.
Let’s take a look at the fixed income side of things. Given the post-Covid equity boom, debt investments have understandably taken a backseat. Over the past 12 months, net inflows into active equity funds have exceeded Rs 3 trillion, whereas actively managed debt funds have attracted less than Rs 1 trillion. This disparity can largely be attributed to the impressive returns in the equity market. For example, largecap equities have delivered annualised returns of 14-15 per cent over the past three years, while smallcap stocks have provided higher returns at 25 per cent. On the other hand, many debt funds have struggled to beat inflation on a tax-adjusted basis, which has made them less attractive. So, what are the prospects of debt schemes, moving forward, and what do they have to offer for investors in the future?
Jajoo: Today, a large portion of fresh investments — around Rs 23 trillion — are being funnelled into bank fixed deposits (FDs). This trend is not just recent; it’s been the case since the inception of the banking system. However, fixed deposits have never outpaced inflation. On the other hand, debt mutual funds, being market-linked products, offer a better opportunity to beat inflation. Yet, many investors have yet to fully understand and embrace them.
If you look back 10 years, there was a similar situation with equity funds. In the early stages of mutual fund growth, equity investments gained popularity as investors began to realise their potential. The same natural progression is likely to occur in the debt space.
Regarding returns on debt funds, it’s important to recognise that there’s a place for every asset class in a growing market like India. While we’re still working to build awareness around debt funds, it’s worth noting that there is no longer a tax advantage for debt mutual funds compared to bank FDs. Unfortunately, a negative perception has taken root, as if debt mutual funds have a tax disadvantage, but that’s simply not the case.
The government previously provided an advantage, but that’s no longer the situation.
The key takeaway is that there are reasons to be optimistic about the future potential of debt mutual funds.
If you’re not seeing significant returns or growth in your corpus yet, remember — it’s still early days, and the opportunities are just beginning to unfold.
Radhakrishnan: While there have been some adverse taxation changes in recent years, let’s set that aside for now and focus on the topic at hand. Debt is an asset class where we typically don’t talk much about valuation, but I believe it’s time we start considering it. Take, for instance, high-grade instruments like a one-year AAA bank CD or a one-year AAA bond. Currently, these offer yields in the range of 7.5-7.6 per cent. With a one-year duration, you can construct a portfolio at this level. Even if we assume inflation to be 5 per cent — slightly above the RBI’s projection of 4.5 per cent — you’re still looking at a real return of over 2 per cent. That’s a compelling argument for fixed income today. And, this doesn’t even account for any potential capital gains that might arise if interest rates fall. Even setting that aside, from a hold-to-maturity (HTM) perspective, a one-year investment offers clear visibility on real returns. Historically, whenever we've had visible real returns like this, debt investments have delivered attractive outcomes. I believe we may be in a similar phase now, where the prospects for debt are looking quite promising.
FPI holdings in Indian companies are at decadal lows. We have seen record selling in October. One can say that FPIs have been tactically reducing their India exposure. Are FPI outflows an impediment to growth of the Indian market?
Gupta: FPIs have been under-invested in India since 2021. To put it into perspective, 20 years ago, FPIs accounted for about 25-26 per cent of India's equity market. Today, that figure has dropped to around 17-18 per cent. This decline in FPI ownership has been offset by an increase in domestic retail participation. While the near-term FPI outlook may remain challenging, particularly with rising US yields and the dollar, India continues to be one of the strongest growth stories in the medium-to-long term. Foreign money will eventually flow back in. An interesting observation is that, despite this under-investment, India's weight in global indices has increased significantly over the past few years. For instance, India’s weight in the emerging market benchmark has risen from about 8 per cent to 18-19 per cent in the last five years. This indicates that FPIs are currently under-invested in India and will likely need to return at some point. Over the past three years, domestic investors have been able to offset the FPI selling, but this was possible because the supply of new issues was relatively small.
Looking ahead, we expect a supply of about Rs 4-5 trillion in paper over the next 12 months, meaning we’ll need foreign capital inflows in addition to domestic equity demand to sustain the market.
Tawakley: As long as India’s current account deficit remains contained at around 1-2 per cent, there’s no need to worry about where the funding will come from. With a deficit of this size, as long as it's kept in check, the necessary funds will flow in. Whether they come in the form of FDI or FPI, or whether they arrive this month or next, it doesn’t matter. From an economic growth standpoint, the key is that the current account deficit is under control and that investment in the economy is on the rise.
With the post-Covid stimulus measures now over, will growth be more challenging, going ahead?
Patil: Over the past four years, growth has been largely driven by significant improvements in operating margins. While top-line growth during this period was not exceptionally high, it was slightly above nominal GDP growth, at around 13-14 per cent. This is similar to the earlier bull run between 2003 and 2008, when top-line growth was around 22-23 per cent. The current growth has been fuelled by better operating efficiency, margin expansion, balance sheet improvements, and deleveraging, which contributed to higher bottom-line growth.
However, much of this momentum has now played out. Moving forward, we see earnings growth aligning more closely with top-line growth, which is expected to track nominal GDP growth, around 10-11 per cent.
Bhan: The challenge is that top-line growth has been weak for the past six quarters, not just today. We are currently at peak margins, with most companies reporting their best margins up to this point. As a result, we should expect earnings to trend higher over the next few quarters, but with a lag.
The starting point for earnings recovery is also more difficult now compared to previous cycles. India is no longer a small economy that can rely solely on broader global growth to deliver high growth rates. In the past, when our economic base was smaller, we saw revenue growth of 22 per cent and earnings growth of 25 per cent over extended periods of 3-4 years. Today, we need to work with improved earnings from the current levels, but realistically, growth rates are likely to be in the lower teens. A 15 per cent growth rate seems challenging, and we believe a more achievable target is around 12 per cent earnings growth, going forward.
Now, even the older generation is pivoting towards equity investment. What would be your advice? How does one approach the fixed-income space?
Radhakrishnan: Ultimately, it all comes down to individual asset allocation choices. Would you want to be 100 per cent invested in equities? There are investors today who proudly claim to be 100 per cent in equities, which itself signals that many are not diversifying enough.
However, when considering relative valuations across asset markets, most investors today should seek diversification.
Diversification is key. Given where we are in the current interest rate cycle, many fixed-income products offer attractive value that can help balance and diversify your overall portfolio. Another approach could be to explore fixed-income investments through hybrid or balanced products, which blend equity and debt to provide a more balanced risk-return profile.
Jajoo: Absolutely. Risk appetite and investment objectives vary from person to person. But conceptually, in India, we have a large number of debt investors — essentially no one is without some debt in their portfolio. The real challenge, however, is bringing those who are still reluctant into mutual funds as a viable debt option.
Even in times of low or negative returns, bank deposits have continued to grow, which speaks to the comfort people have with traditional, low-risk instruments. The challenge for us, as an industry, is how to transition these conservative investors into debt mutual funds. For instance, if someone is earning 2 per cent on a savings account, how do we get him to consider a liquid fund with a 7.5 per cent return? That’s the real hurdle.
The issue isn’t that debt as an asset class isn’t needed — it’s universal. Most of us, whether consciously or not, hold debt in some form.
When we talk about debt in the context of mutual funds, we need to shift the focus from “equity versus debt” to understanding that debt is an essential component of a well-rounded portfolio. Just as we debate between different equity strategies, we must recognise the role debt plays in financial planning. Debt is a necessary investment product, and our challenge is to break the inertia and educate people on how they can benefit from it, especially when they may not be actively considering alternatives to their savings accounts.
Industry has been talking about moderating return expectations for the past couple of quarters but thanks to momentum and fund flows, that hasn’t happened. Your thoughts…
Patil: Even the flows tend to be cyclical also. When the outlook is good, earnings momentum is strong, we see good flows. Flows are also driven by sentiment and past performance. Clearly, the earnings momentum is slowing down compared to the last three years. We have seen sharp corrections in the broader markets as well.
When the benchmark indices are down 5-7 per cent, several stocks are down more than 20 per cent. This could have a bearing on flows. Also, there is a lot of new paper supply that is coming in. We will see companies raise capital to fuel future growth. This supply will help absorb some flows or the demand.
Tawakley: An investment argument based purely on flows essentially aligns with the “greater fool theory.” It’s not advisable to make decisions based solely on market flows. Instead, the foundation of any sound investment strategy should be based on fundamentals.
If the market falls by 15 per cent due to a shift in flows, that could present a buying opportunity, provided your investment is backed by strong fundamentals.
However, if you are buying purely based on the expectation of continued inflows, then the moment those flows dry up, you may feel compelled to sell, even if the stock is down 15 per cent. This creates a cycle where you’re driven by sentiment rather than a rational, long-term investment approach.