Extended valuations cap smallcap upside, largecaps preferred: Marcellus’ Krishnan VR

Despite a 16-month phase of muted returns, valuations across mid- and small-cap segments remain stretched relative to history, limiting the scope for a sharp rebound. Krishnan VR of Marcellus Investment Managers believes large caps currently offer a more favourable risk-reward equation, even as earnings recovery expectations build for FY27 amid a stable domestic macro backdrop.

Edited excerpts from a chat:

What is your assessment of the current market cycle, and where do you believe we stand in terms of valuations versus earnings visibility?

For the last 16 months or so, market returns have been muted with large and midcap indices delivering single digit returns. While domestic macro backdrop looks stable, Nifty 50 forward PE is still above long -term averages. Mid and smallcap indices also continue to be at valuation premium both versus own history as well as compared to large caps despite the derating we have seen over this period. There is expectation of earnings recovery in FY27 partly on the back of improvement in household consumption on back of tax, interest and GST cuts, among others.

What stood out for you in the Q3 earnings season? Are you more hopeful of broad-based growth than before?
Recovery in mass market consumption and acceleration in auto sales was expected due to GST cuts but relatively strong earnings growth among PSU banks, metals and oil and gas stocks was a clear takeaway. Generally, these so called low PE or “value” sectors have rerated on the back of better than expected earnings growth since Covid. A broad based earnings growth across most sectors could be possible in FY27, but I am not sure if it would be sustainable unless quality of job creation and wage growth improve in India.

Which sectors appear structurally well-positioned over the next three to five years, and why?
Structurally we like healthcare services where rising penetration over the next 10-15 years, should be a positive for the likes of hospitals, diagnostics and health insurance. Companies in insurance, RTAs, depositories and wealth management offer attractive plays on the structural trend of financialization of household assets, which is underway.

What is your outlook on financials, particularly in the context of credit growth, asset quality and margin sustainability?
Backdrop looks positive for lending financials. Private banks should see stable to improving Net interest margin in FY27 after a dip last year, as deposits get repriced. Credit growth inched up in 3Q results for most banks and should go up further, if nominal GDP growth accelerates in FY27. Credit costs across most pockets are either benign or returning to normal. The relatively steep yield curve could be a positive for NBFCs, especially housing finance companies.

How should investors approach the IT and digital ecosystem amid AI-led disruption and shifting global tech spending?
Near-term earnings outlook may not be a driver of IT services stocks unless several IT companies were to guide for a decent pick-up in revenues in the next 1-2 quarters. Even though most companies in the space reported stable 3Q results, demand environment remains uncertain. Within IT services, investors should be careful about exposure to BPO or pure software development, as these are among few areas which can be disrupted relatively easily by current Gen AI systems. Given the rapid pace of capability improvements in foundational LLM models seen over last few years, I think the market will be wary of terminal value of most IT services business models and hence investors should not be anchored by historical valuations.

How are you currently positioning portfolios in terms of sector allocation, cash levels and market-cap bias?
We continue to prefer large caps at this point in time given relatively more reasonable valuations. Our investing style is sector agnostic, and we look to invest in high quality companies with clean accounts, strong balance sheets, returns on capital greater than cost of capital for long periods of time, and available at reasonable valuations irrespective of macro or themes.

Do you think that the sell-off in smallcaps we saw in the last 1.5 years is done and that we will see gradual recovery in the next 2 quarters?
We could see a bounceback but I don’t expect another smallcap rally like we saw in 2021 or 2023, unless sentiment or fund flows change dramatically either supported by better than expected earnings growth or higher domestic retail flows, among others. Extended valuations at the index level despite the time correction, also act as a natural ceiling.