Mid, small-cap stocks can bounce back in post-Covid phase

Mid-cap and small-cap stocks have outperformed the large-caps in last one year. How do you see their valuations and returns going forward?

Mid-caps and small-caps have definitely had a good run over the last year, though one needs to remember that, the year before, mid and small-caps had corrected reasonably due to Covid fears. Smallcap index had corrected almost 50 per cent and hence the good returns over the last one year has to be looked upon from that context. Mid-caps and Small-caps have strong balance sheets compared to their own history. They have withstood the challenges of GST adoption, demonetisation and Covid impact and are well prepared for growth over the next few years. Once the problem of Covid spread is resolved through vaccinations, the mid-caps and small-caps will have the capacity to bounce back and drive earnings over the next few years which should eventually lead to good returns.

How do you see the elevated inflation globally and which category of the funds is best suited to shelter an investor's wealth from rising inflation?

Inflation levels have definitely moved beyond the comfort levels of central bank in the near term. The reopening of the economy has seen a surge in demand and the supply side has not been able to keep up with demand. The demand supply mismatch has resulted in elevated inflation levels. The belief is, once the supply side is sorted, one can expect inflation to start coming off in a quarter or so.

Over the longer term, automation, better efficiencies in businesses and availability of alternate energy resources to crude, like solar, hydrogen, electric, etc., should be able to bring down inflation. In the interim, inflation could be high, but one needs to keep a close watch whether it is more structural in nature. Some amount of inflation is good in a growing economy like India, as it adds to the nominal GDP growth. In case inflation comes under control in the near term, which is what the falling US yields are reflecting, equities will continue to be the asset class to rely on for building wealth.

The valuation of the equity market looks stretched from historical perspective. What is your take on this how do you see returns from equity hereon from a three-year horizon?

The valuations in the market look stretched because earnings have taken a knock due to Covid. Corporate India has come through few structural challenges over the last few years, which might have stunted growth in the near term but augurs very well over the long term. Adoption of GST was transformative and so was the case of demonetisation, which have eventually led businesses to formalise or lose out. By the time things were settling down, Covid impacted the economy. Hence the last two to three years have been challenging, but corporate India has shown strong resilience on the back of clean balance sheets and strong operating cashflows.

The increased availability of vaccines and Covid second wave numbers coming under some control is positive for the economy. B2B segments like steel, cement, logistics are doing very well. Lower Covid numbers and higher vaccines should see the B2C segments like retail chains, hotel, mall, multiplexes open up overtime. There is demand across industries, which augurs well for the companies in terms of growth. A growth in profits will eventually get captured in the markets. We remain positive on the markets with a long-term view, though the near term might be volatile, give a strong performance in the last one year. Hence, our take is earnings recovery over the next couple of years should make current levels sustainable.

Is it the right time to invest in mid-cap and small-cap funds?

The markets in general might look a little stretched, but there are decent opportunities across the market capitalisation. Any investor who will come in with a 3-5 year time frame should be able to benefit from rising demand and profits for corporate India. It might not be as easy to be positive on sectors outright as it was last year, but at a company specific level there are lots of opportunities, and hence stock picking skills will be rewarded.

PGIM India Mid-cap opportunities is one of the best performing fund in its category. How the companies in this fund are placed in terms of earnings growth and valuation?

PGIM India Midcap Opportunities Fund has used GARP (Growth at a reasonable price) as their valuation framework. The earnings over the next three years must be able to justify the valuations of a company. This frame work has ensured that companies which come into the portfolio have decent earnings growth and visibility over the next 3 years. The portfolio level earnings growth over the next 3 years as per our internal estimates are above 20 per cent. The strength in earnings lend good support to the valuations of these companies and are reasonably valued in terms of forward valuations.

Why investors need to look at small-cap funds in their portfolio?

The small cap segment has generated very strong returns in the last one year. Hence, one needs to temper down expectations over the next couple of years. Having said that, the strong returns have come after a year, when the small cap index corrected almost 50 per cent and hence over the last couple of years the returns are more realistic. Over the last 3 to 5 years, small caps have underperformed the large caps. Any investor who is looking to invest in small caps, must come in with a 5-year view and in such case should be able to realise good risk adjusted alpha.

Which are the sectors an investor should avoid now and which are the sectors that look promising now?

Sectorally, we have been positive on Information technology, pharma and industrials. IT benefits from the increased adoption of cloud and digital technologies across the world. Post-Covid, healthcare and pharma will gain importance at every household and budgets will go up towards these segments. Industrials should benefit from the capital expenditure plans of corporate India. Capacity utilisation levels are moving up and taxation structure is conducive for corporates to incur capex to meet increasing demand. More importantly, the clean balance sheets will help them undertake capex as and when required. Over the long-term, we at PGIM India are positive on financialisation, digitisation and consumption themes.

In the current market condition what asset allocation do you recommend to retail investors?

Asset allocation decisions will not only depend on market conditions, but will also need to access the investors risk profile and his or her investment horizon. Hence, a single asset allocation template will not be correct. Certain pointer which an investor has to keep in mind is that interest rates offered on traditional deposits today don't even cover for inflation levels. Hence, traditional deposits might be earning them negative returns. Also, earnings growth in the equity markets could be strong over the next two years, which could drive reasonable returns in the markets over the next two to three years.