Mid and small cap MF investors need to tread with caution as equities trade at premium (2024)

S&P BSE SENSEX increased by 1.29% on a total return basis in the month of June-21. After a strong rally in the month of May-21, equity markets have further consolidated gains this month. Sensex has underperformed global indices such as S&P 500 & MSCI world Index that appreciated by 2.34% & 1.52%, respectively, during the month. It has, however, outperformed MSCI Emerging Market Index.

The broader market has done better than the Sensex again this month. The S&P BSE Midcap Index appreciated by 3.66%, and the S&P BSE Small-cap Index rose by 6.98%. Since May 2020, the midcap index has not given a negative monthly return (month on month basis) till-date. Even the small-cap index has given negative monthly returns only once (month on month basis) in the past thirteen months.

Quantum Long Term Equity Value Fund saw a 1.43% appreciation in its NAV in the month of June 2021 compared to a 1.63% appreciation in its benchmark S&P BSE 200.. Cash in the scheme stood at approximately 8.5% at the end of June. We continue to align the portfolio towards the cyclical recovery in the economy without undermining the risk associated with pandemic-related economic upheavals.

The month of June has seen restrictions easing mobility across most states. Improvement in Covid-19 related data (daily new cases, active cases, daily fatalities all are trending down) has given the local state governments some headroom to ease restriction and allow routine economic activity. The monthly economic indicators will show improvement from June-2021 onwards. However, since the lockdown has been less severe this time, we expect the pent-up recovery to be softer than what we witnessed after the first lockdown. Over the next 12 months, sustainability of economic activity and improvement in corporate earnings will hinge upon whether we will have a third wave of Covid-19 infections and another round of lockdown or not. If we can achieve universal vaccination sooner than later & do not encounter the third wave, we will have a faster economic rebound.

ET Online

Monsoons are off to a good start:
The southwest monsoon has progressed well in the month of June-21. The cumulative rainfall for the country has been 18% (169mm) higher than normal rainfall (historical average of 143mm). However, June accounts for just 16-17% of the monsoon rains. July and August are more important months (accounting for 65-70% of monsoon rainfall). The meteorological department has indicated a brief lull in monsoon progress in the first week of July. It could be crucial for Kharif sowing as rainfall distribution is as important (if not more) as the total rainfall.

FII have turned buyers:
After turning sellers for the last two months, FIIs have again turned buyers Indian Equities in June-21. They have bought US$ 2.3 bn worth of Indian Equities this month vs. selling of $ 388 mn in May-21. On a YTD basis, FPI inflows stand at US$ 8.31 bn. DIIs have been buyers in the month of June-21 to the tune of US$ 950 mn. The sharp reversal in global interest rates and recurrence of covid-19 induced uncertainty remains a risk to near-term foreign flows.

Equity Markets trading at a premium relative to history:

Indian Equity markets have welcomed the reduction in Covid-19 active caseload and moved up sharply since mid of May-21. It has continued in the month of June-21 as well. Markets are already factoring in improvement in economic data and pent-up demand. Global markets too remained resilient despite Fed commentary suggesting that rising inflation can result in rate hikes in 2023. The benchmark BSE S&P Sensex is trading close to 22.6x FY22 consensus earnings, while the long-term average PE is close to 18x. So, Sensex is trading at a premium relative to its history. The midcaps & small caps appear even more expensive.

The likelihood of a Covid-19 third wave and another economic lockdown is the most critical variable right now for market direction. Besides that, corporate earnings in the June-21 quarter and management commentary on demand and raw material inflation will also set the tone for future earnings growth trajectory for companies. Another important variable that has emerged over the last few months is inflation. Inflation reading has been higher than RBI’s comfort for a couple of months now. If this high inflation seeps into manufactured goods & food prices, it will force RBI to react with rate hikes resulting in nipping the economic recovery in the bud.

Notwithstanding the market rally & economic uncertainty, equity markets are heterogeneous, allowing active managers like us to find pockets of undervaluation to create a portfolio with a reasonable margin of safety with a long-term perspective. We believe the cyclicals like financials, commodities, and consumer discretionary have the potential to see earning upgrades, in a typical economic recovery environment. Technology stocks are a good play on the global economic recovery. The business case has strengthened for them during the pandemic as technology spends have become part of business continuity plans for corporates across the globe.

Retail investors should stagger their investments to achieve the best results from their equity allocations. Specifically, midcaps & small-cap investors need to tread with abundant caution at current levels.

(The writer is the fund manager-equities at Quantum Mutual Fund)

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