Small, mid cap stocks to lead as earnings growth democratized in India

New Delhi: Small and mid-cap stocks have been the driver of the post-Covid recovery in the markets. Some froth may recede in the coming quarters, but the medium-term outlook remains robust.

Earnings growth has been democratised in India with broader participation across companies, which is reflecting in SMIDs enjoying their time in the sun. Fragmented industrial sectors, with no clear leaders, reinforce the momentum, Emkay Global Financial Services said in a note.

“We see broader markets moving sideways with a negative bias for the rest of FY24. The longer term top-down narrative remains attractive, with small and mid caps leading the markets for the next 2-3 years”, the report said.

The report pointed to three key themes on stocks:

Manufacturing: A multi-year growth trend that is yet to fully play out. This includes capital goods, auto ancillaries, chemicals, metals, and pharmaceuticals. The focus of this theme will be SMIDs, as there are few large caps available.

Premiumization: B2C companies will generally remain laggards, but we see a pocket of opportunity in premiumization. As India’s per-capita income breaks new levels, premium segment growth should get an impetus and companies catering to this segment should outperform.

The technology wave, which has allowed mass-market companies (mainly consumer and BFSI) a non-linear footprint expansion. Internet companies and digital transformers benefit and are the third bucket of outperformers, the report said.

The drivers of growth in Indian stocks are cutting across Financials (ROE normalisation), capital goods and urban consumption, Tata Mutual Fund said in a report.

The recovery in the investment cycle led by healthy cash flows in the corporate sector and the government’s counter-cyclical fiscal policy makes us incrementally positive on the industrial/capital goods sector leading us to progressively increase the exposure to this segment, it said.

Recovery in power demand, capex in generation (renewable + thermal) and transmission implies an overweight stance on the associated sectors/stocks.

In Financials, after a period of margin expansion and lowering credit costs, growth will normalise.

Mid/small caps re-rating has been significant in the last 6-12 months, future upside likely to be more bottom-up based on execution. Large cap banks still reasonably priced.

The report said the corporate earnings downgrade risk has reduced. Banks and capital goods lead the positive earning upgrade cycle.

Urban consumption after significant growth in 2022 is slowing due to the impact of inflation and interest rates. In contrast, rural consumption is picking up, albeit gradually, it said. Pharma downside seems limited as US pricing normalizes.

Sectors with topline risk (e.g IT, FMCG) have stabilized; margins to be supported by lower input costs or easing attrition and wage pressure.

The biggest risk to the market comes from the behaviour of crude prices if there is further deterioration in the conflict in the Middle East. This could lead to reduction in India’s valuation Premium, the report said.

For the year ending September 23, PSU Banks (+76%) and Realty (+36%) made the highest gains while Energy (7%) was the lowest performer. Large cap made marginal gains for the month of September 2023. However, Mid and Small caps continue to deliver alpha, the report said.

A strong momentum in the small cap segment supported by broadening of economic growth and large domestic flows in dedicated funds.

For FY23 the FIIs were net sellers with outflows of close to USD 10 bn while the DII inflows were robust at USD 33 bn. For FY24TD, the FII flows add up to USD 17.4 bn and the DII flows to USD 5.5 bn.

As per Bandhan MF’s Equity Market Outlook, prefer domestic plays to global – however, with valuations/election risk this needs to be calibrated.

Energy transition globally is a theme which can produce some healthy optionality in utilities, capital goods, cables etc.

Sectors exposed to rural/low-end consumption look attractive due to prospects of election spending and waning of COVID/inflation-related balance sheet shocks, the report said.

As nominal growth slows down, niche small caps may provide healthy returns, the report said.

V K Vijayakumar, Chief Investment Strategist at Geojit Financial Services, said "Ideal buy on dip sectors are capital goods, automobiles and financials. Capital goods and automobiles are in a cyclical uptrend and the cycle will last for a few years."

"There is robust demand for capital goods and the automobiles sector will benefit from demand recovery plus margin improvement arising from fall in commodity prices. Financials, particularly banking, are doing well and valuations are lower than historical averages."

The Anand Rathi Research Team said in a note that margin expansion will continue amid rising agri-commodity prices. The IMF has raised its forecast of India’s FY24 GDP by 20bps, to 6.3%. In line with this, we believe Q2 volume growth is expected to come in high single digits despite the festival season falling in Q3.

Although costs of certain commodities have inched up, the likely benefit of low-cost stocks would have boosted margin expansion, driving healthy earnings-growth momentum. Large and small caps are likely to have outshone mid-caps’ earnings-growth momentum.