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Don't see much upside in mid, smallcaps from here: Vinay Khattar, Edelweiss

Both banks and non-bank finance companies (NBFCs) could underperform for the next few months, says Vinay Khattar, head of research, Edelweiss Professional Investor Research.
After a sharp rally from March 2020 low, the market appears ripe for short-term correction, says VINAY KHATTAR, head of research, Edelweiss Professional Investor Research in interaction with Swati Verma. Edited excerpts:

The market has made a remarkable rebound since March-lows. Are the current levels sustainable?

The worst is probably behind us but it's difficult to say whether current market valuations will sustain. The Covid-19 pandemic has emerged as one of the biggest health crises for humankind, massively impacting the global economy as countries were compelled to shut down business activities. At this juncture, the markets are a bit ahead of valuations. The strong rebound has caused the US S&P500 index to move from a trailing twelve months (TTM) price /earnings ratio (PE) of 11 to 22 and Nifty to move from TTM PE of 14.5 to 25. The market appears ripe for short-term time or price correction. That said, this is a market where investors should buy on dips and should utilise volatility wisely.

There's a growing disconnect between macroeconomic data and equity market performance. How long before the reality of economic contraction catches up?

The disconnect is stark. But it is our own sense of looking at the market and economy in the same frame, that needs a correction. At this point, nearly two-third of profits are made by the top 15 companies of the NSE500 Index. Many companies are either exports or from the non-discretionary sector, which has not been too impacted by present problems. The other set of companies are eating away market share from competitors. This means profit pools are still rising for these companies and that is what the market is valuing. At this time, the valuation being ascribed to these firms may get stretched as everyone wants to chase profit makers. In essence, we see this disconnect has deeper roots and may see a correction when the economy stabilises and the non-performing part of the stock market comes back.

How do you view June 2020 qurter (Q1FY21) earnings? The management commentary of a number of companies has been quite optimistic. 

The view earlier was that the Q1FY21 earnings season would be very weak. However, to our surprise, this has been better-than-expected. Management commentary has also been encouraging, although time will tell how the numbers will pan out. But there are pockets of excellence, like chemicals, information technology (IT), select consumption, telecom, insurance, few large banks, and NBFCs, which are doing well. So overall, corporate earnings would not be significantly impacted when we look at broader markets. Possibly, smaller companies with lower moats may get impacted during the next few quarters.

Your view on mid, and small-cap segments?

Mid-and small-caps have been impacted in the past. Markets were completely bullish until the end of 2017, post which, there was a general realisation that Nifty earnings per se, would not be growing over 4-5 per cent and that has been the run rate for a while now. Since 2014-15, Nifty earnings have compounded at an annual rate of 4-5 per cent and within Nifty also, one-third of the stocks have performed, while others have not. On the other hand, there are some segments of the market which are doing very well. The broader market which consists of mid and large-cap segments began to suffer beginning 2018 given developments such as the IL&FS crisis, broader macroeconomic structure, among others. Now, after two years, markets have rebounded strongly. That said, we believe mid and small-caps have reached reasonable valuations post this rally and we don't see much upside, except in sector-specific plays like the diagnostics, information technology (IT) and pharma, and the sectors where government policies have been announced.

Does it still make sense to buy pharma stocks?

Yes, it does makes sense to park money in pharma stocks from an investment point of view. However, there are a couple of things that should be kept in mind. Pharma stocks have suffered a lot in the last three-four years owing to developments in international markets where many Indian generic manufacturers explored and generated a large part of revenues in the US and other western countries. Now, it doesn't mean that story has died down. Also, not all the players in the pharma space will be able to participate in this upside. Companies like Biocon are expected to do well. There are other players like active pharmaceutical ingredient (API) which could play out very well. Companies with a significant presence in generics segment should also do well. Firms with good domestic-focussed business could also do well for the next two-three years. One needs to be selective. 

What about the financial sector?

Both banks and non-bank finance companies (NBFCs) could underperform. The sector is expected to be in slippery and uncertain territory for the next few months as the economy opens up. Restructuring of loans is just one aspect of what has occurred in the financial landscape. It would be crucial to watch what kind of non-performing assets (NPAs) will emerge in the coming six-nine months and the write-offs taken by the banks. Avoid the financial sector for now. 

Your overweight and underweight sectors?

We are bullish on IT, pharma, and select segments of consumption and bearish on the entire banking and NBFC space. We would also avoid the construction and infrastructure space, as the sector is unlikely to do well in the near term until the economy opens up and stabilises. Retail investors should make judicious use of this volatility and stay away from risky names. Companies with weak balance sheets, weak business models, limited or lower ability to generate revenues, should be avoided. Secondly, a steep correction in the market provides an excellent opportunity to enter the stock markets. So, make volatility your friend.

What's your theme for the upcoming conference?

The theme for this conference is "Re-invent", an unparalleled need in current times. We all have re-invented ourselves in the past four months in numerous ways, as we embraced the new normal. Things are fast-changing and technology and innovation will be crucial to surviving these challenging times. India, as a country, is re-emerging too and we remain hopeful that it will emerge stronger, bigger, and better, on the other side of the pandemic.


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