Small need not be beautiful. The sharp rally in stock prices, especially of mid-cap. and small-cap. names without any significant changes in underlying fundamentals, makes us uncomfortable about the nature of the rally. It is perhaps easier to believe the narratives around 'undiscovered' stocks rather than well-researched large-cap. names. We make a few changes to our recommended Model Portfolio as some of our 'wildcard' recommendations have performed rather well over the past 3-4 months.
A joyride can turn into a crash rather quickly
The sharp rally in stock prices, especially of companies with weak fundamentals and limited visible changes to financials and/or operations, makes us quite uncomfortable about the nature of the current rally. It seems we are getting into a zone of irrational exuberance. In particular, we are unable to fathom the bullishness of the market with respect to the mid-cap. and small-cap. names, which are seeing rapid increases in market capitalization without any real changes in their fundamentals. It is not as if the stocks were inexpensive to start with.
Size matters; the smaller the better is the new mantra
We note that the performance of stocks and sectors has been quite varied over the past few months. In particular, mid-cap. and small-cap. stocks have done much better than their large-cap. counterparts. It is possible that the market may have discovered certain virtues in the smaller stocks that were unknown until recently. However, it is also possible that limited knowledge about the 'undiscovered' names may have made it easier for a section of the market to believe narratives about the names. Large-cap. stocks are generally well-researched and it is hard to find new virtues in familiar stories. 'Familiarity breeds contempt' perhaps applies equally to human beings and stocks. It is interesting to see the performance and valuations of various buckets of stocks in our coverage universe.
Index valuations look reasonable but may not mean much
As discussed in our April 10, 2017 note titled The curious case of the Indian market, the valuations of the broad market indices are quite misleading given (1) the wide range of valuations across sectors and (2) the large contribution of 'low' P/E stocks and sectors to the overall net profits of the indices. Even more interestingly, several mid-cap. and small-cap. stocks in the semi-branded businesses are trading at rather rich valuations, which makes us nervous about the potential erosion in market capitalization of the names as and when the market becomes more rational in its expectations about the earnings and returns of such businesses.
Here's a mystery on 'liquidity'
One of the common explanations that we hear about the rich valuations of the market and investors' helplessness to do much about the same is the 'liquidity' argument of large inflows into domestic equity mutual funds (see Exhibit 8). However, it seems that the 'net' investment by DIIs (including insurance companies) in the market is quite low compared to the inflows into the MFs. Insurance companies have been net sellers in the market and cash levels with MFs have perhaps gone up over this period.
Changes to large-cap. Model Portfolio
We remove DLF (200 bps earlier) from our Model Portfolio noting its strong performance over the past four months, roughly the period the stock has been in our Model Portfolio. The stock is up 55% in the past four months. We were 'playing' for (1) value 'unlocking' in the commercial portfolio of DFL (within its 60% subsidiary DCCDL) and (2) a recovery in the residential real estate market by 3QFY18 on the back of sharp increase in affordability (flat residential real estate prices in most metros and 200 bps decline in interest rates over the past 3-4 years).
We include Vedanta with a weight of 200 bps on reasonable reward-risk balance. The stock offers about 20%+ upside to our current fair valuation of Rs290 and even some reduction to our fair valuation on INR-USD changes (stronger INR is negative for EBITDA and valuation) should still result in meaningful potential upside to our revised target price Also, we are increasingly more positive on the global supply-demand balance for aluminum noting the potential restructuring of aluminum capacities in China. The ex-China world market is already in a deficit situation and any removal of Chinese capacity on environmental grounds by Chinese authorities could result in tightening of the market.
We also remove 100 bps from Infosys (900 bps now) and add it to ITC (400 bps now). We are already quite underweight the Indian IT services sector with no 'positions' in other Tier-1 IT stocks.