Mid And Small Cap Stock Correction Still Incomplete: Kotak Report

Domestic equities have seen meaningful price correction over the past week, but the correction seen in mid and small-cap stocks so far is not enough considering the rally these stocks have witnessed over the past few months, Kotak Institutional Equities said in a strategy report.

According to the brokerage, the recent sharp correction in stock prices may reflect a growing recognition of short-term challenges such as higher-for-longer interest rates and medium-term challenges like disruption across sectors. It also reflects a natural correction in the market from high levels, the report added.

KIE report says that the large-cap stocks offer a better reward-risk balance considering more reasonable valuations compared to rich valuations of most midcap and small-cap stocks.

“We do not find value in most mid-cap and small-cap stocks in our coverage universe given the extent of rerating in multiples seen in the past 9-12 months despite weakening business models and eroding business moats,” the brokerage said.

According to the report, the Nifty50 Index has more reasonable valuations at 17.5 times FY2025E earnings per share (EPS) given the moderate earning growth and muted performance of the broader market in recent years.

The brokerage finds decent value in a few large-cap stocks and the BFSI sector only in light of the rich valuations of most stocks in the consumption, investment, and outsourcing sectors.

Regarding the consumption sector, the brokerage said, the rich valuations do not factor in weak demand in the short term and weakening business models in the medium term. The broad-based weakness in consumption and weak volume growth in the second quarter of FY24 is mainly because of weak growth in quality jobs and high inflation in various consumer products over the past 4-5 years.

The report noted that second quarter results for the 20 companies reported so far from the Nifty50 Index have been largely in line with expectations on an aggregate basis despite wide dispersion in reported performance versus expectations. “Most companies in the auto & components, construction materials, metals & mining, and IT services have missed our estimates while banks have beaten estimates. As such, our EPS expectations for the Nifty-50 Index have remained broadly stable over the past few months,” it added.

From the recommended large-cap portfolio, Kotak has removed SRF from the model portfolio because of near-term downside risks to revenue and earnings. SRF appears reasonably valued but there are growing risks to earnings given the likely sharper-than-expected global slowdown and prolonged slump in global demand for chemicals and related pricing pressure.  It has reallocated the weight to HDFC Bank, ICICI Bank, and Reliance Industries Ltd.