Stock market investors in India have enjoyed a grand party in the last four years. Defying grey-haired gurus who asked them to remain sober and expect equity returns of 11-12 per cent, they bet their shirts on equities and have big gains to show for it.

The Nifty50 has delivered a 14 per cent annual return in the last four years, while the Nifty Midcap150 has returned 28 per cent and the Smallcap250 31 per cent.

Now, a 26 per cent compounded annual growth rate (CAGR) doubles a stock in three years. Therefore, multi-baggers have been quite commonplace in this market. Investors, especially those who have joined the joyride after Covid, have come to believe that any stock they buy is obliged to double in a few months, with ‘laggards’ fetching 25-50 per cent.

But when it gets this easy to make money in markets, it means the party is approaching midnight hour. The 9 per cent correction in the Nifty50 since September may be just the first sign that the easy money is behind us.

We believe that stocks, especially mid- and small-caps, may struggle to deliver big gains in 2025 as valuations re-adjust to slower earnings growth. Opportunities for big wins will still exist in individual stocks where the growth-valuation equation is reasonable. But uncovering them will require much deeper research than has been the case in the last four years. Here are our views on equity prospects for 2025.

Valuation de-rating ahead

Bull markets are usually driven by irrational exuberance. But the post-Covid rally in Indian stock markets was not quite irrational. Index gains in this period closely tracked corporate earnings.

In the five years before Covid, Nifty50 companies reported sluggish earnings growth managing only a 5 per cent CAGR between December 2015 and December 2020. The Nifty50 index ran ahead of earnings at an 11 per cent CAGR in this period.

The four years after Covid, however, saw a re-adjustment. Helped by the corporate tax cuts of September 2019 and the consumer splurging after the unlock, earnings of Nifty50 companies expanded from ₹524 in December 2020 to ₹1,069 in December 2024. This was a healthy 19.5 per cent CAGR. The index climbed from about 14000 to 24000 in this period – a lower 14 per cent CAGR.

A similar story played out in mid-caps and small-caps too. Table 1 shows that Nifty Midcap150 companies managed a 38 per cent CAGR in earnings between December 2020 and December 2024, prompting index returns of 28 per cent. Small-cap index constituents saw the index gallop at a slightly higher pace than the underlying earnings growth of 27 per cent.

However, this joyride in stock prices and earnings has now propelled valuations to pricey levels. The Nifty50 now trades at a trailing PE (price earnings) multiple of 22 times, the Nifty Midcap 150 at 40 times and Nifty Smallcap 250 at 31 times. These valuations breezily assume that Nifty50 firms can continue to belt out 15-20 per cent profit growth, while mid- and small-cap firms deliver 30-35 per cent like clockwork.

This sets up the stock market for some sharp disappointments. Ground realities suggest that India’s growth rates, which propelled the purple patch on corporate earnings, are hitting a speed-bump. After racing along at 8 per cent plus until March 2024, India’s real GDP growth has cooled off to 6.7 per cent in Q1 FY25 and 5.4 per cent in Q2 FY25, thanks to a slowdown in government capex and normalising consumption. While the election effect will be absent in the second half, government spending may remain weak. Forecasters therefore expect India’s real GDP growth at 6.5 per cent for FY25 and 6.5-7 per cent band in FY26.

This is bound to impact topline growth for India Inc. Slowing sales for companies is being accompanied by rising input costs which are compressing margins and robbing companies of pricing power for the first time since Covid.

This is visible in the profit growth for Nifty50 companies dropping off a cliff from 22 per cent in March 2024 quarter to under 1 per cent in the September 2024 quarter. Smaller companies have even less pricing power and are more vulnerable to margin pressures. Therefore, Nifty500 profits have slipped into negative territory in the September quarter (Table 2).

While profit growth may chart a revival in the second half, whether the increase will be good enough to justify the pricey valuations of 22 times on the Nifty50 and 40/31 times on the Midcap and Smallcap indices is questionable.

This opens the doors to a valuation de-rating until PE multiples are back in sync with earnings growth. Large-cap stocks are far more reasonably valued than mid- or small-caps. The latter will likely see a sharper course correction to achieve this balance.

Takeaway: Large-cap stocks, the Nifty50 and Nifty100 may not have a very long way to go before valuations re-adjust to earnings growth. These offer the best places to bargain-hunt individual stocks and sectors right now.

Investors seeking mid- and small-cap exposures would be better off taking the fund route and averaging their bets down. Avoid lumpsum investments in small- or mid-cap funds and indices and take the SIP route. The small-cap universe, counter-intuitively, offers a better entry opportunity than mid-caps, which seem quite steeply valued.

Sectoral pockets of opportunity

A market-wide rally where a rising tide lifts all boats is unlikely in 2025. But this shouldn’t lead you to leave the equity party prematurely. Even in the most over-heated markets, there are buying opportunities to be had in the neglected or out-of-favour stocks and sectors.

With growth becoming a rare commodity, markets in 2025 are likely to de-rate sectors that fail to deliver growth and favour the ones that can still get to the double-digits. To identify such sectors, it makes sense to stop focusing on the market aggregates and take deeper dives into sectoral-wise numbers.

Breaking down the Nifty500 into its sectoral constituents, Table 3 shows that while sectors such as energy, materials and utilities have suffered big profit setbacks lately, financials, healthcare and industrials have kept up good double-digit growth. Of these, healthcare offers scope for selective stock-picking as it already trades at lofty valuations. However, financial and industrial stocks still offer attractive opportunities for bargain-hunting.

Takeaway: Based on their valuation-growth equation, value-seeking investors can dive deeper into PSU banks, large private banks, infrastructure companies, agri-themed stocks for buying opportunities. Growth-seeking investors may find opportunities in large NBFCs, life insurers and domestic pharmaceuticals.

Correcting markets also offer opportunities for defensive and income-seeking investors to buy into dividend yield candidates. Both IT and the much-hated FMCG pack offer good opportunities for entering stocks at a 2-3 per cent dividend yield. Mining, metal and financial PSUs also fit the bill, though they need to be filtered for a consistent dividend record.

As the markets are likely to be quite ruthless in derating companies that don’t live up to growth expectations, it may be best to avoid stocks piggybacking on hot themes such as semi-conductors, PLIs, renewables and defence.

Seek quality and low-volatility plays

With a clouded outlook on both growth and liquidity, the Indian market is likely to abandon its one-way climb in 2025 and chart more two-way moves in 2025. This would effectively mean that the styles of investing that worked in the trending market of the last five years may no longer deliver.

A rolling return analysis of NSE’s factor indices shows that Alpha (with a five-year CAGR of 37 per cent), Value (with a 35 per cent CAGR) and Momentum (33 per cent CAGR) were the styles and factors that were the life and soul of the party in the last five years. With the market now likely to behave like a reveller at the fag-end of New Year’s Eve, these styles may give way to more sober ones like Quality and Low volatility. The Quality style filters companies for high growth and Return on Capital, while Low Volatility screens them for low standard deviation.

Takeaway: Lighten up on funds following the Momentum and Alpha styles of investing. Add positions in funds tracking Quality and Low Volatility factors.

Published on January 4, 2025