Despite valuation comfort in largecap stocks, PL Capital’s Vikram Kasat sees opportunity in small and midcaps

Indian stock market investors should capitalize on the growth potential of midcap and smallcap segments while having defensives like largecap pharma, IT and consumer in their portfolio, said Vikram Kasat, Head - Advisory, PL Capital - Prabhudas Lilladher. In an interaction with Livemint, Kasat said there is more valuation comfort in largecap stocks and investors should adopt a cautious yet opportunistic strategy in mid and smallcaps.

Q. Nifty is currently just under 2% away from its record high. Given the earnings growth trajectory, how do you perceive the current market valuations? Is it time for investors to exercise caution?

A. The Nifty 50 is currently trading at a PE ratio of 23.05x, which is 11% higher than the median of 20.75x. While this is not alarming given the healthy earnings growth of the Nifty 50, valuations are stretched in the broader markets. The valuation premium of mid and small caps compared to large caps is near an all-time high, suggesting a need for caution in these segments.

In the short to medium term, the markets are likely to remain range-bound with a positive bias. This outlook is supported by factors such as normal monsoons and the expectation of an interest rate cut in the latter half of the year. To mitigate risks, consider diversification, maintaining a long-term perspective, regularly reviewing your investments, and exploring alternative options.

Q. The Q1 earnings season revealed subdued topline growth overall, with banks and auto stocks within the Nifty 50 delivering stronger performances, while the infrastructure, pharma, and metal sectors underperformed. What are your key takeaways from the Q1 results?

A. Q1 results show Sales, EBITDA, PAT growth of 4.8%, -2.1%, and -5.2%. The results show a variation of 0.1%/0.9%/-0.4% over PL Capital’s estimates.

Auto, Pharma, Hospitals, Durables and Capital Goods reported more than 20% EBITDA growth. Cement, Travel, Metals, Oil & Gas had YoY decline in EBITDA. Building materials, consumer and IT services reported single digit EBITDA growth.

Q1FY25 showed the impact of Lok Sabha elections and severe heat waves in many parts of India. Elections reduced ordering for various Government jobs and contracts. On the other hand, rural demand has started showing signs of sequential recovery with Q1 FMCG growth ahead of urban growth after a gap of several quarters.

Overall, it was a mixed bag and we expect further clarity on FY25 overall earnings to emerge from Q2 onwards.

Q. Following the Q1 earnings season, which sectors you would recommend investors to focus on and why, and which sectors should be avoided going forward?

A. We believe that Capital Goods, Infrastructure, Logistics/Ports, EMS, Hospitals, Tourism, Auto, New Energy, E-commerce, and Telecom are strong themes to consider as policy continuity and premiumization unfold. However, it's important to be mindful of valuations in individual stocks.

While financials form a big part of the index and valuations are favourable, margins are under pressure as deposit rates are inching up. This could continue as interest rates are expected to decline in the second half, so chances of significant outperformance in banks is unlikely in the near-term.

We expect pharma names to do well given benign API prices and little pressure on pricing in the US. In Q1, healthcare delivered positive YoY growth in revenue (15%), EBITDA (23%) and PAT (25%). So investors can look at that sector as well.

Q. What factors are driving gains in the mid and smallcap segments despite concerns over valuations? What strategy should investors adopt in this scenario?

A. Government capex of ₹11.11 lakh crore continues to attract investor attention in the midcap and smallcap segment as they represent sectors like defence, railways, new energy, capital goods. On the other hand, financials and IT take up big weight in largecap index and do not represent sunrise sectors. Increased merger and acquisition activity in these segments have also driven up valuations in the mid and smallcap segment.

Investors should adopt a cautious yet opportunistic strategy. Investors can capitalize on the growth potential of mid and smallcap segments while having defensives like largecap pharma, IT and consumer in the portfolio.

Q. PSU stocks have shown leadership during the recent market rally across various sectors. Do you anticipate this leadership to persist?

A. Government initiatives aimed at privatizing or improving the efficiency of PSUs have bolstered investor sentiment and driven stock prices higher. Additionally, the attractive dividend yields offered by many PSUs are appealing to income-oriented investors. However, some PSU stocks are currently overvalued relative to their fundamentals, which might temper the pace of their gains.

We have seen a recent correction in some defence and railway stocks that are down 20% from their peaks. Despite this, I expect positive momentum to continue, supported by increased order wins, improved revenue visibility, and stronger balance sheets.

Q. Defense stocks have recently cooled down from their highs. How do you view valuations in this space now, and are there any top picks you would recommend?

A. Stocks like Mazagon Dock Shipbuilders, Garden Reach Shipbuilders and Paras Defence have corrected 20-30% from their July highs. This suggests that valuations in this space might have become somewhat stretched. However, it's essential to consider that defence stocks have long-term growth prospects with stable government spending. India's defence budget increased by 4.7% YoY to ₹6,21,450 crore in FY25, the highest among all Ministries. Further, persistent geopolitical tensions around the world can drive demand for defence products and services, which means for more export orders.

India recorded defence exports worth ~ ₹21,100 crore in FY24 (+32% YoY), with the Ministry of Defence targeting ~ ₹50,000 crore by FY29, implying ~19% CAGR over FY24-29. Major products being exported include missile systems (Akash, Brahmos, Pinaka, etc.), armoured & mobility vehicles, electronics, simulators, and artillery guns.

We remain positive on L&T, HAL, BEL but would refrain from giving any targets.

Q. We have seen substantial listing gains, ranging from 100% to 200%, in many SME IPOs. How do you assess this apparent euphoria in the SME space?

A. The relatively smaller size of SME IPOs compared to large-cap offerings creates a sense of scarcity, driving up demand and prices. SME IPOs often represent companies with high growth potential, attracting investors seeking to capitalize on their future prospects. Government initiatives aimed at promoting SME growth, such as Mudra Yojana, gives investors more confidence for SME IPOs. Retail investors, particularly those who have missed out on the gains in larger-cap stocks, may be seeking opportunities in SME IPOs.

However, it's essential to approach this euphoria with caution. While SME IPOs can offer significant returns, they also carry higher risks than large-cap stocks. This is why capital markets regulator SEBI has expressed concern about increased participation in this space.

National Stock Exchange (NSE) has added the condition of positive FCF (free cash flow)-to-equity for at least two out of the three financial years, as an eligibility criterion for listing on NSE Emerge. This ensures investor protection as well as growth of SME companies seeking funds.

Q. FPIs have turned net sellers in Indian markets this month after two consecutive months of buying. There is a noticeable trend of overseas investors selling financial stocks heavily while shifting towards defensives. What is your perspective on this development?

A. The recent unwinding of the Yen trade is what caused the selling in financial stocks. It was expected, as FIIs are overweight in financials. In June 2019, FPI sector allocation to financials was 43%, which has now decreased to 31.5%. With geopolitical tensions and fears of recession, FIIs appear to be booking some profits to maintain liquidity for potential buying opportunities.

Q. Global cues appear mixed—while markets are optimistic about a potential US Fed rate cut, geopolitical tensions in the Middle East and the crisis in Bangladesh are dampening sentiment. How might this global landscape influence Indian markets?

A. Globally, India remains one of the fastest growing economies with 6.7% 5-year average GDP growth rate. The potential for financialization of savings in India is huge as demat penetration is only 11%. Coupled with the fact that the US Fed rate cut is looming in the second half of the year, it only means a positive trajectory for Indian capital markets.

However, the extent and duration of geopolitical tension resulting in any logistics issues can result in an increase in input prices. This can impact margins of India Inc. While the fears of a recession in developed markets have subsided for now, any economic data suggesting otherwise will make investors cautious and can trigger some panic selling. Investors are in wait and watch mode which is why markets may remain rangebound.

Q. What is your target for Sensex and Nifty 50 for the end of 2024?

A. We value NIFTY at 15-year average PE (19x) with March 2026 EPS of 1411 and arrive at a 12-month target of 26,820. In Bull Case, we value NIFTY at PE of 20.2x and arrive at a bull case target of 28,564. In Bear Case, Nifty can trade at 10% discount to LPA with a target of 24,407.

Q. Could you name five stocks that you believe are fundamentally strong and well-positioned for long-term growth?

A. Since markets are rangebound and there is more valuation comfort in largecaps than broader markets, here are five stocks that are well placed over the next 12 months.

ICICI Bank

• Well poised to sustainably deliver core RoA of 2.1%.
• Target: ₹1,520

Mahindra & Mahindra

• New model pipeline, with increased offerings at multiple price points.
• Target: ₹3,330

InterGlobe Aviation

• Premiumization plans with launch of a business class product.
• Target: ₹4,958

Larsen & Toubro

• Strong international prospects led by Middle East and healthy domestic pipeline
• Target: ₹4,130

Max Healthcare Institute

• Strong expansion plans (+3,000 additional beds over FY24-27E)
• Target: ₹975

Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of Mint. We advise investors to check with certified experts before making any investment decisions.