Midcap, smallcap stocks’ outperformance to continue for next 6 months; these sectors may gain most | INTERVIEW

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August 31, 2020 1:07 PM

The midcap rally is still in a nascent stage and macro uncertainties still persist. In this scenario, balance sheet health becomes extremely critical for risk-reward to be attractive.

midcap stocks, small cap stocks, COVID-19, dollarThe unlock phase will lead to sharper earnings bounce for Indian companies which might boost performance in midcaps

Midcap stocks have started catching up over the last two months, after underperforming for more than two years. The trend of midcaps outperforming large caps should continue in the coming months as well, said Niket Shah, Fund Manager, Motilal Oswal AMC. In an interview with Surbhi Jain of Financial Express Online, Shah said he believes that even as FY21 is likely to see a decline in GDP growth over FY20, a sharp recovery will be witnessed in FY22. He further says that whenever there is a recovery in GDP growth rates midcaps tend to outperform large caps. One of the factors which will aid midcap performance is the unlocking phase in India. Shah believes that the unlock phase will lead to sharper earnings bounce for Indian companies which might boost performance in midcaps.

1. Midcap and smallcap stocks have outshined equity benchmarks in August so far. Where do you see them in 6 months from now?

Yes, midcaps and small caps have started to outperform after underperforming significantly over the last two years. In fact, midcaps are outperforming across the world. Over, the next 6 months as well I expect the outperformance to continue. Three main arguments for our thesis is as follows:

a) Improving global liquidity propels midcaps across the world: Mid Cap outperformance over large caps has been a global phenomenon in the last couple of months – as seen in Russell 2000 outperforming S&P 500. Also, improving global liquidity is usually a harbinger of midcap outperformance. If historical correlations were to hold true, then the midcap outperformance is at a very nascent stage.

b) Dollar weakness bodes well for broader market participation: Aggressive policy response by both – US government as well as the Fed has resulted in dollar weakness. Historically, dollar weakness has always broadened market participation.

c) India’s unlocking beginning to happen: As compared to most parts of the world, where unlocking has been taking place, we were yet to see this in India. Though quite late, India’s unlocking is finally happening and thus we believe this will also lead to sharper earnings bounce for Indian companies in the forthcoming quarters versus that in other countries in the ensuing months. This scenario of improving earnings also aids midcap performance.

2. What is your outlook on consumption stocks amid the corona pandemic? What are your favourite picks from this sector?

Consumption sector can be divided into two parts- FMCG and discretionary. While we believe FMCG and consumer staples are likely to do much better due to the essential nature of demand and increase in-home consumption, the consumer discretionary companies are likely to have the steepest and most difficult road to recovery. This is because, under COVID, households which are likely to bear the maximum brunt of a cost-cutting exercise, are done by corporate. While wage bill growth has been slowing for a decade now, what’s surprising is that even pre-COVID employee expenses as a % of sales have been rising as sales have collapsed. It is only natural that corporates will look to revert this ratio and hence wages are likely to remain under pressure for a very long time. This is seen in management commentary across the board in Q1FY21. The problem is further compounded by the sharp tightening of lending standards across retail loans. Thus, demand, especially for discretionary consumption, is likely to remain under pressure. This along with high valuations makes the risk-reward for consumption pack quite unattractive for consumer discretionary names.

3. Midcaps have started performing over the last two months, post its underperformance for more than two years. Which stocks do you think have potential to rise?

We have seen companies with higher export exposure have performed much better than domestic plays. This is because globally stimulus is far stronger than domestic (as seen in a much stronger broad money supply growth). Hence, those companies with higher exports share should benefit. Second, we like structural stories like chemicals and electronics where valuations are high but we see strong and sustained growth potential for years to come given the government Atma Nirbhar policy impetus. Further, the midcap rally is still in a nascent stage and macro uncertainties still persist. In this scenario, balance sheet health becomes extremely critical for risk-reward to be attractive. Historically, it has been observed that after a crisis it’s typically the cash-rich/healthy balance sheet companies which outperform. We expect this time to be no different.

4. What according to you should be investors’ strategy amid volatility in the market? Which sectors do you prefer?

Dollar weakness is now giving a good fillip to risk sentiments. The global safety trade is unwinding – with sector leaders now underperforming their respective sector laggards. This is most stark in sectors with structural tailwinds and cash-rich sectors such as IT and pharma, where sector leaders are one of the worst-performing stocks YTD. Also, within sectors, the rally has been broadening – wherein sector laggards are outperforming sector leaders. COVID 19 has led to tailwinds for certain sectors over the medium to longer-term like Insurance, Diagnostics, Pharma, IT (Increased focus on digital), Auto (Focus on personal mobility) and Chemicals (Atma Nirbhar mission). We continue to like these sectors from 2-3 year view.

5. Global brokerage firm Morgan Stanley is also bullish on the broader market. Do you think, mid-, small caps will continue to outperform large-cap peers in coming months?

Going by various points highlighted above, we strongly believe that global liquidity and dollar weakness will ensure that this trend of midcaps outperforming large-caps should continue in the coming months as well. While FY21 is likely to see a decline in GDP growth over FY20, we expect a sharp recovery in GDP growth rates in FY22. Our view is that the market is pricing in future recovery. Historically we have seen that whenever there is a recovery in GDP growth rates midcaps tend to outperform large caps. The key risk to the same is the second wave of infections worldwide and a delayed second round of global and India fiscal stimulus.

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