In conversation with Mohit Mittal, Director of Investment Research, Acuity Knowledge Partners
It is important to look for stocks with solid fundamentals, strong end-market demand and robust FCF generation, states Mohit Mittal, Director of Investment Research, Acuity Knowledge Partners
What are the key risks facing equity markets at this point?
Indian stock markets have performed strongly in 2023, particularly in the last three months. While the indices are near all-time highs and valuations do not look cheap compared to historical averages, we continue to believe the outlook for equity markets will remain strong, driven by resilient macroeconomic growth (the Reserve Bank of India [RBI] expects 6.5 per cent y/y growth in FY23-24), broad-based recovery in the manufacturing and construction sectors, stabilising interest rates, foreign fund flows and robust domestic demand.
Key risks in the near term would be the potential effect of El Nino on the monsoon, which could impact the rural consumption story and accelerate inflation. Moreover, supply-side disruptions in global commodities can impact prices and lead to inflationary pressures. In addition, the possibility of a slowdown in the US and European economies continues to loom and can further hurt export demand and the services sector. While the Federal Reserve (Fed) has paused rate hikes at the moment, two more hikes are expected given the strong job markets and sticky inflation. Further hikes by the Fed may force the RBI to resume rate increases. It is noteworthy that the RBI paused rate hikes in the last two cycles after raising the benchmark repo rate to 6.5 per cent from 4.0 per cent in April 2022.
While valuations do not look cheap for Indian markets and the global risks persist, pockets of opportunities are available in the market. The focus should be on quality stocks with sound balance sheets and long-term growth potential; dips should be used to accumulate. From a sector perspective, defence, construction, infrastructure and banking look favourable, driven by strong domestic factors, while IT and pharma look uncertain, due to demand factors from the US and European economies. From a valuation perspective, the mid-and Small-Cap stocks are still trailing their Large-Cap counterparts compared to the long-term historical valuation multiples.
In the current market conditions, what asset allocation strategy would you suggest for investors?
Considering equity indices’ valuations are near historical averages, with pockets of opportunities, and uncertainty in inflation and rates persists driven by global pressures, investors should adopt a dynamic strategy allowing for changes as per market conditions. For a balanced portfolio with modest risk exposure, the portfolio mix could be equities (60 per cent) and debt (40 per cent). Given the high-interest rates, investors may consider allocating an additional 10 per cent to debt (50:50) to maximise capital gains on debt securities when interest rates decline in the coming quarters. Investors are also sitting on cash as they wait for the right entry point for equities.
What are the three sectors that you think appear promising and would you like to invest in for the long term?
The manufacturing, infrastructure and construction sectors are expected to perform well going forward, as the improved capex cycle and the likely reversal in the RBI’s stance on interest rates (if not immediately) are likely to boost stocks in these sectors and lead to a moderation in operational costs. Increasing government spending on infrastructure, and a strong Make in India push could help these sectors maintain their strong performance in the long term, aided by China’s geopolitical issues.
The banking sector is likely to perform well in the next one or two quarters on healthy asset quality, robust capital ratios and strong macroeconomic growth, which is expected to propel credit growth for at least the next few years. In addition, the high-rate environment is expected to help banks sustain margins in the near term. The Indian banking system has remained robust while banks in the US and Europe failed recently. Strong domestic credit demand, led by manufacturing, infrastructure and consumer, is likely to keep banking stocks in investment portfolios.
The consumer sector is also expected to maintain momentum, due to the strong domestic consumption expected over the next few years. However, the valuations of some consumer stocks are elevated. Hence, investors need to be cautious while picking these stocks. In addition, the defence sector will continue to perform well, buoyed by the Make in India push and geopolitical concerns globally.
The IT and pharma sectors remain subdued, due to a slowdown in the US and Europe (with Germany officially in recession). These sectors may resume a healthy growth cycle in the next 4-6 quarters.
Given the recent strong performance of small-cap stocks over the past six months, what is your outlook for small-cap stocks for the remainder of the year?
The Nifty Smallcap 100 Index advanced 10 per cent YTD 2023, with the majority of the gain made in the last two months. Still, the small-caps stocks are trading at a discount to their 5/10-year average and appear to not have participated in the market rally over the past two years. Given that the large caps are already trading much closer to their long-term average valuations, small caps are likely to catch up over the next one or two quarters. Controlled inflation, improved capex cycle, easing supply chains and the RBI’s outlook for stable interest rates are likely to drive the stock prices. Moreover, foreign portfolio investors are pursuing these stocks with large liquidity. That said, investors should be watchful about the businesses they are investing in. It is important to look for stocks with solid fundamentals, strong end-market demand and robust FCF generation.
Disclaimer: The opinions expressed above are personal and may not reflect the views of DSIJ.