First, let’s talk about the discussion or debate between the largecap space and the midcap space. Where do you actually see value right now, considering that a lot of largecaps are currently playing catch-up compared to the broader markets?
Madanagopal Ramu: It’s a debate about how you look at the short-term and the long-term. If you look at largecaps, they’re clearly struggling with structural growth of less than, say, 10%. So that means if you invest in largecaps over the next three years, you can get a return of between 10% and 12%. But if you look at midcaps and pick the right stocks, India has always produced a lot of these midcap and smallcap companies that have grown structurally and even delivered over 20% earnings growth over a long period of time.
And if you can invest in some of these names, but focus very specifically on the midcap and smallcap space, then I think you have the opportunity for higher returns.
But if you invest in mid and small caps at the index level or if you invest in a very diversified portfolio, you have to worry a little bit about that because the downturn can hurt you. That is not the case at all because the mid and small cap sectors are doing well.
Many of these companies have traditionally suffered under the domination of large companies in the same sector.
Has anything changed structurally? These investors can be rewarded. But wherever there is no structural change and they have benefited over the last two years due to capital flows in the mid and small cap sector, there are many of them.
There is a long list of stocks that have benefited from an economic upswing, but it is short-lived. However, when the economic cycle turns unfavorable, you will find that many of these mid- and small-cap stocks struggle to justify the valuation they are currently trading at.
So, if you manage a portfolio of 100 midcap stocks, or even 60 midcap stocks, the slide that has helped you over the last two years will soon hurt you.
The same is true for smallcap funds too, so here the investor has to be very selective. But if you are able to pick the stocks in the mid and smallcap space that can deliver 20% growth over the long term and are trading at a reasonable if not cheap price (because you can’t get anything cheap today given the increased valuations in the overall market), then I think you have a real chance of giving investors a 20% return over the long term. Those opportunities exist, but the number of those stocks has come down significantly over the last year or so.
Continuing this conversation, you said there is some scope but the scope might be limited when you talk about the size of the pool at this point in time. We have seen a strong rally in the mid and small cap space, the PSU sector in this space has also seen a strong rally. We are seeing a kind of correction creeping in across this space. Where would you say at the moment is there scope for a 20% return portfolio or a 20% return portfolio when you talk about the sector themes?
Madanagopal Ramu: There are certain big long-term trends that are happening simultaneously in India and globally. When you consider that there is a global energy transition, it is clearly underway. Because after so many decades of fighting for clean energy without government subsidies at commercial prices, I think it has now become a reality. With the capacity expansion in China, both in solar cells and lithium-ion batteries, in both energy sources, I would say one for power, the other for mobility, we can envision a scenario where we can add many of these energy sources at a price that is lower than fossil fuels.
So you’re going to see an increasing adoption of electric vehicles, especially in countries like India, because battery prices have come down significantly over the last year and you can now bring electric vehicles to market at almost the same price as a combustion engine vehicle.
So this can lead to a big change. Also on the energy side, we can imagine that renewable energy, supported by backup storage, is quite possible at a lower price than this fossil fuel, or at least at the same level.
We think there’s a new opportunity here given what’s happened in the last six months with battery prices and solar cell manufacturing prices. So we think this transition is going to create a lot of opportunities if investors are paying attention, and in a lot of these opportunities, the balance sheets of these companies and the ROCE of these companies are much better.
So this is a range of stocks that you can look for there. Another area where I think the market has not made any significant gains yet but can make a significant return in the next two to three years is the NBFC space. The NBFC space has seen the margin compression story in the last year or so.
Good companies with growth of over 20% are still not rewarded as much as capital goods or infrastructure companies, which benefited from this last year.
So if you pick the right names there that can continue their growth momentum at close to 20% and more and are trading at reasonable valuations because valuations have not gone up in this space, we think you can get a meaningful return there if you buy and hold for the next three years.
In the consumer space, except for big names like Trent, Titan and Zomato, there are not many consumer companies – I am not referring to staples here, but mainly to companies in the non-consumable sector.
Discretionary companies in the QSR space, in the healthcare space, we are finding some of these ideas with good value on the table, not many, but there are opportunities in there. So those are broadly three areas that we are focusing on and we think we can find a handful of companies with about 20-25 stocks with a reasonable valuation. They are not cheap. They are probably trading at a fair value, but their earnings growth is much better than the broader index or even the large cap Nifty.
We believe Nifty should have earnings growth of around 10-12%. If we can create a focused portfolio with growth of around 20%, it is quite possible and available at a reasonable valuation so that we can get those kinds of returns.
Which area do you think is off-limits right now as there is a sharp increase? Would capital goods even be on that list? Do you think the tremendous growth the sector has experienced will now stall for a while?
Madanagopal Ramu: See, what happens in a bull market is we start to think of everything as a structural growth story, but not many of them turn out to really be a structural growth story. Many of them turn out to be cyclical markets.
But last year was a year in which earnings also benefited from the tailwind of the raw materials sector following the Ukraine war.
So we feel that a lot of this was extrapolated into many areas, and we also had the scenario that the narrative gained strength with political stability after the election.
Therefore, many thematic funds were used. We also observed that mid- and small-cap stocks continuously benefited from capital flows, first from foreign mutual funds, later from domestic and most recently from thematic funds.
And most of these thematic funds are in the mid and small cap space. They are predominantly focused on mid and small cap sectors. So we cannot rule out a situation where there could be a valuation overshoot that has built up in a large part of the mid and small cap space, if not all of it. So I particularly believe that where a lot of thematic funds are flowing today, I’m not saying there will be big drawdowns, but there could be a scenario, the risk is different here. There could be a scenario where the money that flowed into thematic and small cap assets and so on in say June or July is probably not going to generate higher returns than fixed deposits over the next three to four years.
So when these developments happen and a lot of money is raised and flows back into the same illiquid area of mid and small cap themes, I think you should avoid that and be very selective. I’m not saying avoid, but be very selective, then you will avoid the risk of underperformance over the next two to three years.
