'High smallcap valuations temper return expectations'

Midcap and smallcap companies' annualised earnings growth is expected to be 8-9 per cent higher than that of largecaps. This outperformance is crucial for their relatively high valuations to sustain, says HARSHA UPADHYAYA, chief investment officer, equity, Kotak Mutual Fund (MF). Over email with Abhishek Kumar, Upadhyaya says domestic-facing sectors like automotive, cement, and construction are a better bet right now as global uncertainties prevail. Excerpts:

- HARSHA UPADHYAYA

Midcaps and smallcaps have outperformed largecaps by a wide margin this year. How have valuation differentials changed?

Midcap and smallcap segments have outperformed the largecap segment by over 20 per cent in the past 12 months. The outperformance has been significant since the pandemic lows as well. Consequently, on a relative basis, midcaps and smallcaps have become more expensive than largecap stocks.

In terms of relative earnings yield, there is currently no margin of safety in midcap and smallcap segments.

Do you expect the tables to turn next year?

For higher relative valuations for midcaps and smallcaps to persist, earnings delivery will be crucial going forward. We anticipate an 8-9 per cent higher compound annual growth rate (CAGR) in earnings for midcaps and smallcaps over largecaps in the two years, 2023-24 (FY24) through 2024-25 (FY25), and meeting this expectation is essential for the valuations to sustain.

How does one play the smallcap theme now?

Staggered and disciplined investments in diversified smallcap MFs with a long-term orientation are advisable.

Additionally, investors should temper return expectations compared to the recent past and also be mindful of rich valuations, which could result in higher volatility than in the recent past.