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India Equity Strategy Report - Small and mid-caps: wind in their sails - HDFC Securities

Posted On: 2020-09-13 22:24:13

Mr. Varun Lohchab, Head Institutional Research, HDFC Securities

SEBI's circular mandating multi-cap funds to allocate at least 25% of their AUMs in mid and small-caps each by early Feb 2021 has come as a surprise, given the large AUMs currently under the multi-cap category. We believe some of the large multi-cap fund schemes might opt to reclassify into (or merge with the existing) "large and mid-caps" category, given the difficulty of managing sizeable AUMs with a high proportion of relatively less liquid Indian mid and small-caps. However, this mandate would still lead to forced inflows into mid and small-caps over the next four months, especially small-caps, given the sizeable gap between existing and proposed holdings across most schemes. As per current holdings and no scheme reclassification, this shift would lead to an outflow of ~Rs. 350bn from large caps (top 100 stocks by market capitalisation) and inflows of ~Rs. 130bn into mid-caps (next 150 stocks), and ~Rs. 280bn into small-caps (beyond the top 250 stocks). As per our analysis, these inflows would amount to ~1.2% of total free-float of mid-caps and a whopping ~7% for small-caps.

We believe quality small caps that were impacted in the past two years by investor apathy and flight to safety might continue their strong show, which has been visible in FY21 YTD. Investors should remain disciplined and stick to fundamentals while selecting small-caps, given the fact that economic headwinds might persist for a while, and valuations for quality mid and small-caps are not mouthwatering after the run-up. We continue to see selective bottom-up investible ideas with favourable risk-rewards across all market caps. Consumer, IT, Pharma, Chemicals, Cement, and Agri/rural might remain the preferred sector choice for investors in the near term. However, we also see this as a potential catalyst for rerating of ignored stocks in the economy-facing sectors such as Infra/Industrials, Hotels, Auto Ancillaries, Financials and Real Estate, if there is a confluence of strong balance sheets and attractive valuations.

Interestingly, in some of the above sectors, the themes of "big becoming bigger" and "winner takes it all" do not hold true, given the fragmented nature of business and niche opportunities, which makes a multi-year investment case for strong small-cap business models within these sectors. High divergence of valuations between large caps and mid/small caps emerged over the past two years in sectors such as Consumer, IT, Cement, and Financials, which might normalise to an extent, helped by this catalyst and high retail investor interest.

- Our top mid-cap research picks are Mphasis, ACC, Crompton Consumer, IGL, Gujarat Gas, Max Financial, JK Cement, Endurance Technologies, Persistent, and Aarti Industries.

- Our top small-cap research picks are CDSL, KNR Construction, Alkyl Amines, Galaxy Surfactants, Radico Khaitan, PNC Infratech, Brigade Enterprises, Sonata Software, Mastek, and Ahluwalia Contracts.

- Our model portfolio already has a good blend of mid and small caps with a weightage of around 15%. We further add Persistent Systems, Aarti Industries, Endurance Technologies, and Radico Khaitan to our model portfolio and reduce our weightage in ICICI Prudential and Bajaj Finance.

Source: Equity Bulls

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