Surging domestic liquidity is distorting the valuation metrics between large caps and the broader mid and small caps.
New wisdom seems to have dawned on the Indian equities. “Less is More” is a moving theme now in the mercurial Indian markets. What has intrigued seasoned investors is the emerging divergence in the valuation pecking order. Investors are used to larger caps commanding rich valuations compared to lesser mortals from the small cap space. The rationale for that was simple. Large companies have proven business model, scale, governance practices and management depth. Smaller companies suffered from market’s skepticism on those metrics. But that dictum hardly drives valuations now in Dalal street. Large caps are no longer at a lofty premium to their less fortunate cousins. Multiples in mid and small caps have soared recently to put large cap valuations at a deep discount. On PE valuation basis, much of the large caps are at a large discount to the broader middle and smaller cap space. Below chart captures this trend brilliantly.
Confluence of certain combinations have come together to conspire this bizarre change in the valuation norms in Indian markets. The divergence between FIIs and domestic liquidity is at the root of this growing trend. While FIIs have been on an aggressive selling spree, domestic inflows have surged to new high. Most of the new inflows into domestic mutual funds have been into mid and multi-cap funds. As one estimate puts it, the share of flows into such mid and multi-cap funds is over whopping 80% in the last 12 months. Add to this, the growing trend of return-hungry HNIs shifting money from not-so-rosy real estate to equities. Much of this new money is finding solace in small and mid cap space while FII’s aggressive exits have been largely in the top end. This contrasting behavior has distorted the valuation metrics between large caps and the broader space.
So far it is just fine. Where the story gets scary is in the micro-cap space (below 500cr market caps). Extrapolating the growing trend of out-performance in small and midcap space into micro-caps, many new micro-cap masters have sprouted all over the markets with their new found multibaggers. Micro caps never had it so good. With micro cap investing emerging as a new hot success mantra, the risks have risen manifold.
While some of the froth has been washed away by the ongoing correction, valuations in the broader space remains still high relative to previous cycles. With no let up seen in domestic liquidity ( both from mutual funds and form HNIs), valuations may remain at elevated levels for long in the broader space, thereby limiting opportunities for bottom up stock picking. Hidden gems are no longer hidden. Ironically, for value investors, deep-dive no longer delivers value. It is top-down rather than bottom-up for a while till this distortion lasts.
Happy Value Investing!
Hidden gems to hidden worms – what a quick change of sentiments in the small and midcaps space. New breed of stock geniuses miraculously surfacing in the last few months in the social & mainstream media with their instant multi-baggers suggested simmering froth in small and micro-caps. With the bubble popping out in this space ( going by deep cuts in ongoing trading sessions), there is no hiding place for these new micro-cap masters.
Classical fear cycle is on play in this space. It is increasingly possible that the fear cycle can feed on itself to wreck the markets into manic meltdown. More so, when the commentary and narratives in the mainstream business media fuel such a frenzy by feeding malicious mis-information in a magnified manner. Look at how perennial bears mysteriously appear in the mainstream channels with their over dose of pessimism just when things turn tricky. Programs like “crystal ball” with sensational Shankar Sharma ( First Global) anchored by cynical Udayan Mukherjee promptly appear in such times to provide lethal bullets to bears, thereby raising risks of domestic redemption cycle.
If this correction morphs into a manic meltdown, what should long-term investor do. They should simply keep their shopping carts ready for the eventual fire sale. India is in such a stage of an economic cycle where interest rates are coming off with moderating inflation and investment cycle just turning. It is one of the bright spots in a relatively weakening global macro. While China’s slowing growth and its management will be a huge overhang for global markets, over time, flows will gush into promising markets for its returns, slowly decoupling from China. India will stand to gain from that decoupling because of its relative advantage.
Investors who need more comfort, can take cues from this brilliant chart on BSE Sensex returns from intra-year lows ( source : JP Morgan) plotted since calendar year 2000. In almost every year, without exception, returns from intra-year lows have been positive and have scaled in double digits in most of the years including the year 2008. That much for market’s sanity. With or without China, overbought markets would always correct and oversold markets would rapidly rally with or without hard landing. Every bull market year has a vicious fall and every bear market year will have virtuous rally. That is the nature of markets. Deciphering too much into Chinese deluge without this basic understanding is akin to missing the woods for the trees.
The key to execution is to conserve and build cushion of cash ( when going is good) to capitalize on correction opportunities that ensue every rally. Fund managers who had anticipated and built cash positions prudently should be rejoicing the emerging mouth watering opportunities in the broader space where bubble has popped out post its recent gravity defying gyrations. Interesting times for bottom up stock picking!
Happy Value Investing!!