Expert view: Valuation not a key challenge for large, small-cap segments, says Nikhil Rungta of LIC Mutual Fund

Expert view: Nikhil Rungta, co-chief investment officer of equity at LIC Mutual Fund, believes contrary to popular perception, valuation is not a key challenge for large and small-cap segments. However, the mid-cap index trades significantly higher than its respective fair forward multiples, posing a major challenge for this segment. This stretched valuation is primarily due to about 15-20 per cent of the index constituents trading at very high multiples. In an interview with Mint, Rungta shares his views on the market outlook, expectations of Fed rate cuts and what Indian stock market investors should do at this juncture.

Edited excerpts:

Most triggers look fairly discounted in the market. What drives the Indian stock market?

While the rally in the Indian equity market is often discussed, the improvements in corporate earnings receive less attention.

Contrary to the consensus expectation at the start of FY24, which predicted Nifty earnings growth of 12-13 per cent, the actual growth was almost double.

Mid and small-cap companies performed even better, explaining the outperformance of mid and small-caps over large caps.

This is partly due to the catch-up effect, as mid- and small-cap indices underperformed large caps during 2018-22.

The key drivers of the Indian equity market rally are robust macroeconomic performance, strong corporate earnings growth, and rising allocations of domestic investors into equity assets. As long as these factors remain favourable, the rally is likely to continue.

That said, markets are inherently volatile, and a 10 per cent correction within a year is common and can occur due to various triggers. Historical patterns suggest that the market typically rebounds from such corrections within three months.

Therefore, while short-term corrections are possible, a positive view is maintained for the Indian equity market from a medium to long-term perspective.

What do you think is the biggest challenge for the market in the short term?

Our analysis suggests that large-cap and small-cap indices are trading close to fair price-to-earnings valuation multiples based on one- and two-year forward earnings.

By fair valuation, we mean the median one and two-year forward price-to-earnings levels for the last ten years.

Therefore, contrary to popular perception, valuation is not a key challenge for large and small-cap segments.

In contrast, the mid-cap index trades significantly higher than its respective fair forward multiples, posing a major challenge for this segment.

This stretched valuation is mostly due to about 15-20 per cent of the index constituents trading at very high multiples.

Hence, a few overvalued mid-cap stocks pose a risk of significant correction for those stocks rather than for the segment as a whole.

The possibility of large cross-border equity portfolio outflows may not be seen as a major challenge for the Indian equity market.

During phases post-pandemic, when up to $30 billion outflow occurred within 12 months, the market did not correct significantly due to strong domestic institutional buying and counterbalancing foreign institutional investor selling.

The rising equity allocation by Indian households since 2016 represents a structural change in investor behaviours and is unlikely to reverse.

The key challenges for the Indian equity market at this juncture are unfavourable global developments and broad-based restrictive measures by the domestic regulators.

How can investors balance their portfolios between the sectoral mutual funds to achieve diversification?

Historically, many sectoral mutual fund schemes delivered significant returns.

However, the performance variance among schemes within this category is one of the highest among all mutual fund categories, indicating a large divergence between sectoral mutual funds.

Investors need to be very cautious when choosing particular sectoral mutual fund schemes.

Unlike diversified mutual fund schemes, where the investor may remain invested for prolonged periods, sectoral mutual fund schemes require more nimble choices by investors and switching between schemes based on the underlying fundamentals of the relevant sectors.

For investors seeking diversification, investing in multiple diversified mutual fund schemes may be a better option than numerous sectoral mutual funds.

How do you see the Q1FY25 earnings of Nifty 50 companies so far? What could be some notable upgrades and downgrades?

So far, about 60 per cent of large-cap stocks by index weight and nearly 30 per cent of mid and small-cap stocks have reported their Q1FY25 earnings.

As expected, on a quarter-over-quarter basis, there is an almost 10 per cent earnings dip for large and small-cap indices, while mid-cap indices have seen flat quarter-over-quarter earnings growth.

On a year-over-year basis, earnings of large-cap companies remain flat, primarily due to the oil and gas sector.

Excluding this sector, large-cap earnings growth is close to 10 per cent.

Both mid and small-cap indices maintain positive year-over-year earnings growth, with mid-caps recording low teen growth and small-caps in single digits.

Our assessment suggests potential rating and earnings upgrades for financials, auto, and healthcare sectors, while global cyclicals like oil and gas and metals may face downgrades.

What are your expectations for the US Fed rate cuts? Do you expect the rate cut cycle to be substantial or shallow?

The Federal Reserve rate cuts are expected to begin in September 2024. The consensus forecasts at least a 75-basis point cut during the current calendar year, but we anticipate a more conservative 50-basis point cut. Eventually, the rate cut cycle could be substantial, but the pace of easing may not be too rapid.

What should investors' strategy for the market be at this juncture, considering the variables of rate cuts and geopolitical factors?

It is crucial to recognise that Indian equity remains among the preferred asset classes not only in India but also among major economies, even in dollar terms.

However, equities can be more volatile than most mainstream asset classes.

Investment in equity assets requires a horizon of at least three to five years.

Therefore, equity allocation should be strategic rather than tactical. For individual investors, it is prudent to gain equity exposure through mutual funds, as fund managers manage investments full-time.

Studies have shown that 90 per cent of portfolio return variability comes from asset allocation, with less than 10 per cent attributable to specific security selection or market timing.

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Disclaimer: The views and recommendations above are those of individual analysts, experts, and brokerage firms, not Mint. We advise investors to consult certified experts before making any investment decisions.