Smallcaps set to be largest contributors to current profit upcycle; here’ why

The broader market indices have a significantly higher weight in the domestic cyclical sectors, and they could benefit from the current demand environment in the economy, they said.

“Our PAT/GDP framework indicates that the capex cycle driven by infrastructure, real estate, leisure, manufacturing, etc. is continuing; this can drive peak corporate profit cycle ahead and small-caps will be the largest contributors to this upcycle given their large overlap with the aforementioned sectors,” the analysts said in their report.

While there are concerns around the valuation bubble in the mid- and smallcap segment, one of the reasons why we haven’t seen any indications of a bear market yet is the favourable macroeconomic conditions in India and healthy earnings growth, they added.

Empirical evidence suggests that high valuations, followed by weak economic growth and high interest rates typically trigger bear market selloff in mid and .

However, the current environment is contrary to this as India recently saw an upgrade in GDP estimates and the outlook on interest rates also remains benign.

While expectations are being tempered on interest rate cuts immediately, the consensus

view is that interest rates will moderate hereon, even if it remains higher for longer.

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Top Picks
The brokerage firm prefers those mid- and smallcap stocks which offer adequate ‘margin of safety’ with an earnings yield >5%, or robust growth with a PEG < 1.5x.

Based on this, the brokerage has picked 31 stocks from the small and midcap universe. The top 10 picks are , Shyma Metallics, , , Gulf Oil, , , , , and CIE Automotive.

Risk Factor

The only risk factor is the pricey valuations of small and midcap stocks.

The brokerage firm’s ‘size allocation’ framework has been signalling that smallcaps are at their most unattractive relative valuation zone in terms of their risk premium over largecaps, although it is getting mitigated in the recent correction.

In case any major unknown risk-off macro event was to play out, then small and midcaps currently offer low margin of safety in terms of their ‘earnings yield spread’. This is even after the recent correction in stock prices.

Given that such assets have relatively low liquidity only exacerbates the problem in a risk-off environment, the brokerage firm said.

(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of The Economic Times)