After 30 months of struggle, global brokerage firm Morgan Stanley believes that Indian small and mid-cap stocks are ready for outperformance on the back of a growth recovery and attractive valuations.
Small and mid-cap stocks went into a prolonged phase of underperformance after peaking in early January 2018. Between the end of 2017 and March 2020, the broader market indices were down more than 40 percent relative to the BSE Sensex.
"At the end of 2017, SMIDs were trading at 50x trailing earnings, more than twice the multiple for the narrow index (BSE Sensex). The relative PB was 0.9 times the large-cap index and well above its 25-year average of 0.6 times. Thus, the market was expecting the small and mid-cap stocks to beat the benchmark in terms of earnings growth and deliver similar ROE," noted the brokerage report.
However, that did not happen. Growth slowed down due to a variety of factors including the GST law, the real estate regulation act, the bankruptcy code,and the new inflation framework – all of which may have dragged down growth in the near term, even if they were positive for long-term growth, said Morgan Stanley. It added that demonetization in November 2016 may have been a bigger drag on medium-term growth than was believed at the time.
These policy actions may have been particularly difficult for smaller firms and the onset of COVID-19 in February 2020 and the subsequent lockdown worsened matters for these firms.
But lately, the broader market's relative performance is helping as a forward-looking stock market is possibly anticipating better growth. And with monetary aggregates normalizing and significant policy action underway with a corporate tax cut last September, the brokerage believes growth is set to turn.
"We believe that the reversal in relative SMID performance, which began in April 2020, is likely to continue. Once the impact of COVID-19 ebbs, the cumulative policy response plus monetary system normalization should once again bring back growth, in our view," it said.
It added that smaller firms are likely to benefit more due to their operating and financial leverage. The valuations for mid and small cap stocks are looking attractive relative to GDP and money supply, setting the stage for outperformance versus large cap stocks in the coming months, it explained.
"Valuations of SMID stocks are looking more attractive, setting them up for a re-rating if the growth outlook improves as we think it will. Relative P/B is down to 0.75, though ideally, this would be lower than its long term average. The considerable profit damage inflicted over the past two years has also depressed book values (compared to larger companies) distorting multiples," Morgan Stanley stated.
Here are the top small and mid cap stock picks by the brokerage:
First Published: IST