At a time when markets are hitting new highs almost daily, broader markets have also joined in the rally. Both midcap and smallcap indices have also been hitting multiple record highs since June. Just in the previous session, both Nifty Midcap and Nifty Smallcap indices hit their respective new highs.
Kotak Institutional Equities, in its latest report, said that it is bemused by the regular emergence and rapid uptake of investment themes and their disproportionate impact on stock prices of mid-cap stocks.
In many cases, eventual outcomes turned out to be disappointing versus the market’s initial narrative of strong growth and high profitability for a long period of time, noted the report.
It further stated that it has witnessed mostly this in (1) MFIs/SFBs, (2) consumer durables and apparel and (3) specialty chemicals, where the outcomes did not live up to the narratives.
Let's analyse each sector to see how they did not match the Street expectations:
When MFIs/SFBs were the flavor: The brokerage pointed out that microfinance institutions (MFIs) and small finance banks (SFBs) traded at high multiples throughout FY2015-19, with the belief that their business models were robust enough to generate high and sustainable return on equity (RoEs) for a long time. However, the narrative ignored the inherent weaknesses of unsecured lending to bottom-of-the-pyramid borrowers, where loss given default (LGD) can be as high as 100 percent during periods of stress, it noted. Further, it said that frequent man-made and natural calamities exposed the weakness of the business model, with high limited liability partnerships (LLPs) and dreadful RoEs during periods of stress.
When consumer durables and apparel were the flavor: In this case, the brokerage highlighted that consumer durables and apparels stocks saw a sharp expansion in their multiples over FY2014-19 with the (valid) assumptions of (1) large under-penetration and (2) rising per-capita income under-pinning the narrative. However, the sector has seen disappointing growth and profitability, of late, suggesting over-estimation of market potential and under-estimation of competitive threats, it informed. Multiples have sustained at high levels, with stock prices following earnings downgrades. As per the brokerage, the market may still be too optimistic on profitability.
When specialty chemicals were the flavor: The brokerage noted that the sector had seen steady rerating over FY2013-19 on (1) expectations of Indian companies making ‘easy’ gains through China+1 and (2) delivery of strong and profitable growth. However, the assumptions of consistent growth from the sector have been upended recently due to (1) aggressive fightback from China and (2) worsening domestic competitive dynamics, with companies foraying into the products of other companies, it pointed out. As such, the Street had to revisit growth and profitability assumptions for the sector, leading to sharp earnings downgrades, it stated.
Now manufacturing is the flavor: This is the newest chapter in a familiar playbook, mentioned Kotak, with the market building in (1) a long runway for growth, (2) high profitability and (3) strong returns for mid-cap. ‘manufacturing’ companies. Mid-cap ‘manufacturing’ companies, especially in the capital goods, defense, EMS and renewables sectors, have witnessed exceptional performance recently. The narrative does look powerful, however, it noted that similar narratives in other sectors have not played according to the market’s lofty expectations, with eventual outcomes being somewhat disappointing versus the narrative.