Mid and small-cap stocks have rallied a lot in 2021, pushing up their valuations beyond historical averages and of large-caps. What’s expected in 2022?

Valuation and earnings growth, two counter-acting forces, will influence the performance of mid and small-caps in 2022.

The fact that mid and small-cap segments had lagged the markets for two years up to 2019 set a favourable base for their strong performance in the subsequent market recovery. A cyclical recovery phase, especially from a crisis level, is normally quite conducive for this category to outperform; this proved to be the case, post Covid.

After the outperformance over the past 18 months, the valuation of the mid and small-cap category looks quite high; both against the trend as well as versus large-caps. This high valuation is likely to weigh down their relative performance.

Also read : Large-cap stocks 2022 outlook by Sohini Andani of SBI MF

The trauma of Covid has impacted this category’s operating performance more, in the form of production disruptions, intermittent market closures, raw material price volatility and credit availability. As 2022 starts to see normalisation on such fronts, the rebound in earnings from mid and small-cap segments can be sharper.

The moot question is whether the earning growth will be robust enough to deliver returns from current valuation levels. As the liquidity-induced sugar-rush abates, valuation is likely to normalise to some extent. These factors warrant a cautious outlook for mid and small-cap segments for 2022.

That said, these segments generally work more from bottom-up stock selection and opportunities continue to exist in select pockets. Franklin MF adopts a bottom-up approach to stock picking and looks for a combination of sustainable quality, growth and acceptable valuation in all segments, including mid and small-caps.

Also read : US stocks 2022 outlook by Siddharth Srivastava of Mirae MF

Where do you see good investment opportunities in this space today?

Some broad themes that could do well over the medium to long term include the following:

(i) Domestic cyclical growth orientation: Recovery in economic growth being led by multiple factors bodes well for the domestic cyclical sectors, which are the initial sectors to benefit from cyclical uptick. Banks, construction, industrials, materials, discretionary sectors, could be key beneficiaries of economic growth recovery.

(ii) Consolidation and shift of market share from unlisted players to large, listed ones: This trend has been unfolding over the last few years. Key large players in many sectors have grown faster than respective industry averages. Increasing formalisation of the economy due to push from regulation such as GST and societal trends like digital adoption have helped this trend. The last five-year phase that has seen multiple crises and the resulting tepid growth has tested the resilience of the smaller players in many industries and has diminished their competitive position.

(iii) Higher growth in manufacturing: The ongoing geo-political tension has clearly spurred interest in supply sources other than China. The targeted promotion plans of GoI, like the PLI scheme, appear to be more effective than earlier plans. Increased level of FDI will also help improve India’s participation in the global supply chain. The robust export numbers so far this year are a pointer in this direction.

Also read : Fixed income 2022 outlook by Amit Tripathi of Nippon India MF

Are small-caps and mid-caps more vulnerable if the liquidity-driven rally comes to a halt?

Generous liquidity has helped global markets so far since the Covid crisis. This has clearly peaked. The sticky level of high inflation has led to the US Federal Reserve reversing its stance on interest rates and monetary stimulus. The ongoing taper programme will probably gather momentum as we go forward. This adverse trend in liquidity will likely affect equity valuations, more so in case of stocks/sectors with very high valuation levels. Investors need to be careful with stocks, not just mid and small-caps alone, whose valuations are very high relative to their past trend or that of peers.

Let us not forget that the Indian economy is at the start of a cyclical upswing; the two-year period up to Covid saw a sharp downswing. If the strength of the earnings recovery over the next 3 years is robust, an investor need not base his/her view solely on falling liquidity. A more balanced view that considers the medium-term growth prospects, along with falling liquidity, would be appropriate.

Also read : Gold 2022 outlook by Chirag Mehta of Quantum MF