Excess Froth In Small- And Mid-Cap Stocks Drained, Says ValueQuest's Ravi Dharamshi
Investors cannot fully embrace India's growth story without having exposure to small and mid caps, says Dharamshi.
The correction in the mid- and small-cap space was much needed, and the excess froth has been drained from the system, according to Ravi Dharamshi, chief investment officer of ValueQuest Investment Advisors Pvt.
There was a certain level of leverage in the margin funding book that also needed correction, he told NDTV Profit's Niraj Shah in an interview. "I won't be surprised if it corrects some more from here."
Dharamshi, however, suggests to exposure to small and mid caps. Investors cannot fully embrace India's growth story without having exposure to the small and mid-cap sector, he said.
Electronic Manufacturing Services
"Semiconductors are the new oil as our entire lives are dependent on electronics. I see a window of opportunity in the electronic manufacturing services sector," he said.
India has long overlooked manufacturing as a foundational industry. The country has never seriously attempted to become a manufacturing base. Today, there is a window of opportunity as the world suddenly realises they are too dependent on China for their supply chain, according to Dharamshi.
"It is crucial for a country like India to be self-reliant in semiconductors. The electronic manufacturing services sector will be a significantly larger sector 10 years down the road."
Watch the interview here:
Edited Excerpts From The Interview:
Ravi, a few days back in one of your tweets, you said that maybe FII flows haven't been that strong but India is unignorable for FPIs, if not now, then over the course of the next 12-24-36 months. Can you talk about the basic premise around that?
Ravi Dharamshi: See, India has already become world’s number four market cap, at $4.2 trillion. Of course, there is the U.S. which is like the mothership and then there is every other market out there.
But in terms of one of the fastest growing economy and in terms of one of the largest market cap, India, till date remains a very, option kind of thing, where a lot of the FII participants in the past have not participated because of the low level of liquidity but there are certain points that cannot be ignored.
One, we remain the fastest growing economy. Second, now we offer depth in the market. The period from October 2021 to March 2023 was the 18-month period where we had $40 billion of outflow, which led to only 16-17% correction at the index level. So that tells you that India has depth. We have now domestic flows worth about $40-45 billion coming in annually, pretty much stably, because of the SIP flows, EPFO and insurance money that we are getting on a monthly basis. Of course, there will be some absent flow over there but largely, I think $30-35 billion is not going anywhere. So India offers depth as well.
Then it offers breadth. The kind of sectors that India has to offer, not many emerging markets offer. So, India has been clubbed along with the emerging markets and because of that, I think that's a great disservice because we have financials, technology, new-age businesses, and renewables. Many new sectors are getting added. We have a manufacturing base, which is growing. So not every economy, or every emerging economy has this kind of wide representation of sectors in the market. So that is one more reason why it should not be ignored.
And then, coming to the fact that, FPIs historically have been far higher allocated. Today India is at about $4.1 trillion kind of a market cap. FIIs own about $680 billion of it, which is 16-16.5 % kind of an exposure. It's historically at a lower number. We have had exposure as high as 24-25% in the past as well. If I were to compare it with actually the desirable money like long-only, sovereign, pension, endowments, their exposure is even lesser. Now on the other hand, our weightages in the MSCI or FTSE have been constantly rising because of the increase in the free flow and because of the performance. So that is actually leading to even passive flows, which will have no choice but to come to India. So all these factors put together point to the fact that FIIs will have to make India not an optional, not a good-to-have market, but a must-have market in the future.
Are large institutions like yours comfortable with the valuation argument? One can argue that India has always been expensive. Therefore, valuation shouldn't come into the picture. But somehow in almost all narratives, all sell-side notes, the valuation numbers do come into the picture. So, how do you argue against valuations?
Ravi Dharamshi: No, one cannot argue against valuation, but there are two parts to the valuation—one is absolute valuation in itself and second is premium to the other markets. I think that premium to other markets is a flawed argument that we should ignore.
Absolute valuation on its own, yes, of course, you need to enter at a point of time where the odds are in your favour. But as compared to other emerging markets, or even as compared to some of the other developing markets, I think we offer a much better growth profile and much better ROIC profile. We are at a stage in the cycle where we are still rising. So from that perspective, I think expansion of the premium is very much justified. If somebody is making a case for reversion to mean of that premium, I think that is a very tactical call and I don't think over a long period of time the premium will sustain and probably the gap will expand also.
See, I think one should be cognizant of some of the structural changes that have happened in the Indian economy. We have always faced twin balance sheet problems in India—whether it is current account deficit or fiscal deficit. I think we are on a path. Again, I might be jumping a little ahead of the curve, but in a 3-4-year horizon, possibly we might be on the path to correcting this twin deficit.
Look at the way the tax numbers are panning out. Look at the way our exports have now started growing and the balance of payment is now coming under control. And we have achieved all this without giving any kind of a fiscal stimulus and that gives me a lot of confidence that there might be finally light at the end of the tunnel that will bring this twin balance sheet problem under control. Now if that kind of thing was to happen, the only thing that we lack as against the U.S. is a reserve currency. But even over there, I think the RBI has done a fabulous job of managing volatility. Over the last two years, virtually the rupee has been the most stable currency.
So if that kind of background is there, and if we can showcase that we can sustain this for a long period of time, I think India deserves premium valuation. So, again, absolute valuation, yes, you have to look at the company that you're buying into, but the argument of premium versus other markets, I think, there might not be reversion to mean as compared to what it was maybe say 10-15 years back.
My inference of what you put out on X a few days back was that while SMIDs are expensive, the earnings momentum in select SMIDs, in select pockets, bottom-up ideas is so strong, that it will make up for the valuation mismatch that exists currently. Is that true for a large universe or a very narrow universe within the small and mid-cap space?
Ravi Dharamshi: Thanks for that question. First of all, I would like to make a distinction over here. A lot of people start with the premise that I will invest in mid cap, small cap, large cap. Probably if you're a mutual fund investor, it means a lot to you to classify the market in terms of market capitalization.
But if you're a stock picker, if you are a bespoke portfolio manager, how does it matter? I am creating a portfolio of 10-15 stocks. See, SEBI has a straitjacketed definition that the top 100 companies of this country are large caps, 100-250 or mid caps, and 250-500 are small caps. Now, even as compared to the global markets, our largest mid caps are way bigger than the mid caps globally. Our largest small cap is way bigger than the small caps globally. So, with the expansion of the market cap, $4.1-4.2 trillion, obviously the size of the companies will also rise. Now I have heard that mutual funds are asking for the expansion of the definition of the large cap itself.
I am against the idea of having a starting point of market capitalisation to where you are investing. You have to look at the businesses, the businesses that are going to do well in the next five years. Now necessarily, usually in the sunrise sector, there will be no large-cap companies. Large-cap companies are in mature industries where the companies have been in existence for 30-40-50 years. Not to take away anything from that. But you cannot expect earnings to compound 20-25% over there or you cannot expect a major re-rating over there, unless those companies have not been delivering for 5-7-10 years. Then, you tend to have a possibility of an earnings growth as well as a re-rating possibility. So I have a fundamental issue with classifying the market into mid and small cap.
But having said that, if we still want to look at what the market is thinking and how one should be thinking about it, clearly a lot of flows have gone into small and mid caps. I said earlier that $2 billion of SIP, $1-1.5 billion of insurance and EPFO money, roughly 40-50% of that money has flown into small and mid-cap schemes of the domestic mutual funds. Now that has led to some expansion in the multiple and the valuations have gone a little out of hand. That's why we are correcting at this juncture.
This correction was very much required and all the froth probably has gone out of the system. There was some amount of leverage in the margin funding book and that also needs to get corrected. Still probably a lot of these people are sitting on gains even after this correction. So I won't be surprised if it corrects some more from here.
But the point is that when the profit cycle in an economy is on the rise, like we are, from the bottom of Covid times, the corporate PAT to GDP (ratio) is increasing. In that scenario, usually the universe tends to expand. The number of sectors doing well tends to expand, the number of companies doing well tends to expand and you can't be riding the India story without having any kind of a small and mid-cap exposure.
So tactically and reversion to mean, maybe large caps do well in the next six months but I would say over the next five-year horizon, you don't want to lose sight of the forest for the woods. You still want to identify businesses, companies, sectors, themes—regardless of their market capitalization—that are going to do well over the next five years.
Jefferies is constructive on the EMS sector. Ravi, the argument for or against EMS could only be on valuations because the growth numbers look solid. How are you approaching this because you are among the early identifiers and early investors here. How do you think about it now?
Ravi Dharamshi: See, if you dial back to two-and-a-half decades back, when IT sector was a sunrise sector, these companies were growing at 70-80-100%. They continued growing at that rate for a period of almost half-a-decade and then, they slowed down. They came to 100%, then went to 60-70%, then went to 30-35%. Eventually, now, today they are growing in single digits. So I'm saying every industry goes through this kind of a phase, any sunrise industry. So electronic manufacturing, I'll definitely put in that sunrise sector. India has long ignored manufacturing as a base. We have never tried to become a manufacturing base.
Now today, there is a window of opportunity because the world has suddenly realised that they are too dependent on China for their supply-chain. A lot of people say this is deglobalisation. I say this is not deglobalisation. This is realignment of the global supply-chain. So some of that will be near-shoring, some of that will be friend-shoring, some of that will be on-shoring. So India is part of the friend-shoring, part of the realignment of the supply chain. So within that, the key obviously semiconductor is the new oil. Our entire lives are dependent on the electronics that run around us. And the semiconductor and electronic value chain forms a major part. It is important that a major country like India is self-dependent on many of these things, or at least, have some part of the value chain over here. Now with the advent of mobile manufacturing first, we managed to get the OEMs whether it's Samsung or Apple. Any kind of supply-chain shift will happen from the lower end first which is at the assembly level. Then, gradually from assembly, it will move to components. Then it will move to sub-assemblies and then probably the entire product and then eventually we'll have brands coming out of India. This is usually the line of development followed by most countries.
These companies that we're talking about are still very, very small. Their absolute revenue sizes are Rs 2,000-3000 crore, as compared to some of the large giants like Foxconn and Pegatron, which are in billions of dollars. So what I'm saying is this sector will be a much larger sector 10 years down the road. That goes without saying. However, identifying a winner over here and of course, the growth has to be a profitable growth—these are the two challenges that we will be facing in this sector. This sector is not like technology which is not capital-intensive. This is a working capital-intensive sector. So you will have to keep involved and it will probably have cycles which will be slightly more pronounced than in the IT sector. So those are some of the nuances of this particular sector. But the absolute, physical growth of this sector cannot be denied. So, you have to look at the valuations in conjunction with that fact that the absolute size will be so large, these companies will become Rs 1,000 -2,000-3,000 crore PAT companies over a 10-year horizon. Then, do you want to sell out at a slightly higher valuation at this juncture, because the current market is factoring in a little bit too much of the future? So I cannot rule out a 30-40% drawdown but you have to look at a 5-7-year horizon. Can these still be a multiplayer force over that horizon? I would tend to believe yes, but of course stock-picking and you have to put in that caveat that not every company will be a sustainable wealth creator. You have to do your work and figure out which will have the most profitable growth and sustainable growth.
A company which is trading at 70 times might be trading out there for a reason too because the market really likes its execution or future growth potential or whatever. Do you approach this pocket that way that if a company is so expensive, then necessarily get out of it?
Ravi Dharamshi: So you know P/E multiple is a backward looking measure of valuation, if you're especially looking at the TT MP multiple, the last trailing 12 months.
Everything about P/E is about the past while everything about the stock is about the future and your returns are dependent on what pans out in the future. So you're absolutely right. You should not get hung up on one particular metric in terms of valuation. You have to look at it in context of the size of the company. You have to look at it in context of the cycle of the sector, stage of the sector and how this can pan out. A 70 P/E multiple can be cheaper than a 30 P/E multiple also and a 30 P/E multiple can be cheap and 10 P/E multiple can be expensive also, depending on what determines the P/E multiple, what is the consistency of earnings, the rate of growth of earnings, perception about the company. All these things go into determining the P/E multiple and I think you have to actually ask yourself, why is this company quoting at a 70 P/E multiple versus this company which is 30 P/E multiple and it requires a little bit of second order, third order thinking which will tell you maybe the profile of this company is slightly better and maybe the growth rates are slightly better so it deserves a better multiple. And then you see it in context of the absolute size rather than taking a call on the current earnings multiple because your returns will depend on what pans out in the future.
Consumption. Are you playing it via premiumisation route because some of those routes are well-discovered and well-priced, or do you believe there is value in staples? They have virtually gone nowhere in the recent past.
Ravi Dharamshi: I think I would bring consumption-related stories on my radar now. Consumption has been very, very skewed post-Covid. The top end of the consumption stories, have done well. The bottom end has not done well. So whether it is about hotels, travel, real estate, premium real estate, those are the kind of consumption stories that have done well, post-Covid.
But bottom end of the staples, whether it is the rural consumer, those stories have not panned out very well, due to multiple reasons. One of them being the buying power at the lower end was not much. Second, probably the anticipation of recovering post-Covid did not pan out as expected and that led to filling up of channels and some of that stock correction has led to correction over there as well. But you have to understand that we are still $2,500 per capita. In fact, we are not even $2,500 per capita. We are very much at the beginning of the stage from where we can have a 10-year journey. When this $2,500 goes to $4,500, that can lead to a huge boom in the discretionary consumption.
India is still a largely consumption driven economy. So we have to always keep that on the radar and the last three years of underperformance kind of gives me that confidence that now is the time to start looking at some of these stories. I might be early in it. They might still have 2-3-4 quarters of bad performance or no revival. So we are constantly looking for those triggers.
Some of the trickle down of the private capex cycle might happen, some of the MSP rises and dearness allowance rises might lead to a little bit of revival, or a good monsoon might lead to a little bit of revival. But still, we don't have everything in place to say that the stars are aligned and the consumption is going to boom. So that's why we are right now keeping it on the radar because the valuations are also now finally reaching some kind of a semblance from a longer term perspective. They used to quote very, very high. So it's a fertile area to keep looking at from the next 12 months point of view.
