Morgan Stanley analysts Ritham Desai and Sheela Rathi expect small- and mid-cap (SMID) stocks to outperform large-caps in the coming months on the back of growth recovery and attractive valuations.

Their top picks are Aditya Birla Capital, Amara Raja Batteries, Apollo Hospitals, BEL, CG Consumer, Gujarat Gas, GSPL, JSPL, Indraprastha Gas, Jubilant Foodworks, MphasiS, MCX, Narayana Hrudyalaya, PNB Housing, Prestiege Estates, Shriram City Union, Shriram Transport, Sobha and Tata Power.

“With monetary aggregates normalising and significant policy action under way with a corporate tax cut last September, we think growth is set to turn. Smaller firms are likely to benefit more due to their operating and financial leverage. SMID valuations are looking attractive relative to GDP and money supply, setting the stage for outperformance versus large-cap stocks in the coming months,” the analysts said in a report.

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 SMID indices were down more than 40 per cent relative toBSE Sensex.

Recovery in the offing

The normalisation of money supply over the past six to nine months was also accompanied by a major policy response in the second half of 2019, which led to a big cut in the corporate tax rate in September 2019. In addition, the government took calibrated sector-specific steps for housing, exports and autos in H2-2019. “In our view, this was what probably took India's PMIs to seven-year highs in February 2020 before the impact of Covid-19 kicked in.”

It is clear that the Covid-19-related lockdown created pain for Indian businesses and probably took some small firms to the brink of closure, with high unemployment, and risk aversion in the banking sector further compounding the problems. Yet, the usually forward- looking stock market stopped penalising the SMID cohort at the end of March 2020.

“We believe that the reversal in relative SMID performance, which began in April, is likely to continue. Once the impact of Covid-19 ebbs, the cumulative policy response plus monetary system normalisation should once again bring back growth,” they have opined. This would benefit the broader market (i.e., the SMID universe) more than large companies since smaller companies have greater operating and financial leverage, the report further said.

Better valuation

Valuations of SMID stocks are looking more attractive, setting them up for a re-rating if the growth outlook improves. 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.

“To us, the informative valuation metrics on the state of the broad market are how the market ex-Nifty trades relative to GDP and M2 (money supply). Both are well below averages and just off lows. Given that we are in the midst of a liquidity driven stock market, the market cap to M2 ratio tells us how much upside the broad market bears before we are done with its nascent rally,” the analysts added.

Prolonged lockdown due to Covid-19, lack of structural reformss in land, labour, agriculture, privatisation and investment and tail risk in the financial system pose key risks to the outperformance of SMID, according to the report.

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