Why FIIs could continue moving out of largecaps and into mid and smallcaps: Motilal's Rajat Rajgarhia

Foreign investors’ rotation out of India’s large-cap bellwethers and into mid- and small-cap stocks may have further to run as global funds hunt for companies whose earnings can potentially double or triple, according to Rajat Rajgarhia, Managing Director and CEO–Institutional Equities at Motilal Oswal Financial Services.

With several of India’s top 25 companies still delivering single-digit growth, Rajgarhia said the stronger earnings momentum is increasingly concentrated beyond the large-cap universe. “I do not see that trend changing in the near future,” he told ET Markets on the sidelines of Motilal Oswal Financial Services 22nd Annual Global Investor Conference.

Edited excerpts from a chat:


The theme of this year’s Motilal Oswal Financial Services 22nd Annual Global Investor Conference is “From Challenges to Compounding Opportunities”. What are the biggest challenges that you see for long-term investors?

If you look at India over a long period, the country has done well. However, the past two or three years have presented several challenges, including tariff-related and war-related issues.

Corporate profit growth slowed, foreign institutional investors recorded substantial outflows and the currency came under pressure. The past two-and-a-half years have been a period in which the markets have had to navigate several challenges. Artificial intelligence was also the dominant global trade, and India did not have significant participation in it.

After this period, I think the era of compounding in India is returning. Earnings are gradually recovering, and this was one of the best quarters for earnings. The Reserve Bank of India and the government have also been proactive through the measures they have taken.

Foreign investors have probably sold more than they ideally should have, but domestic investors supported the markets very well during this phase.

While artificial intelligence is expected to remain a dominant theme for the next decade, allocations to the trade may have become overcrowded. The phase of FII selling seen over the past two years also appears to have stabilised.

India is normally a compounding market. In some markets, you have seen indices and the largest companies double or triple. Reliance Industries, our largest company by market capitalisation, does not necessarily double; it compounds. That is the theme of the event: moving from challenges to compounding opportunities.

I see three important risks. First, the aspirations of India’s top 50 or 75 companies need to become much larger. We have been through a phase in which companies focused on preserving their balance sheets and distributing capital. That now needs to give way to expansion and, where required, borrowing.

We recently heard the Paytm CEO point out that the biggest companies globally undertake annual capital expenditure of $100 billion to $150 billion. India may have three to five groups investing at scale, but we need that broader investment culture to return.

Second, interest rates could still moderate from here. When an economy enters a capital-expenditure cycle, the cost of borrowing becomes an important factor.

Third, as India is now among the world’s five largest economies, global trends need to become more stable. How can businesses plan if they face a 50% tariff one year and oil at $100 a barrel the next?

Either businesses must learn to plan for an uncertain world, or the world needs to become more predictable. Many investment decisions have been put on hold because the external environment became highly unpredictable. If businesses are told that the next 10 years will remain unpredictable, they will have to re-engineer their business models for that environment. That is the next major issue businesses are trying to address.

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Motilal Oswal’s recent report described the latest quarter as “picture perfect”, with Nifty profit growth at its highest in 10 quarters. How would you assess the earnings season for the broader market?

India is seeing the reverse of what is happening in markets such as the US or Korea, where the top five companies are attracting most of the attention and delivering the growth.

If you look at India’s top 25 companies, including large information-technology and consumer-goods companies and some banks, their growth rates remain in the single digits. The innovation and rapid growth are occurring outside these companies—in new businesses, among new entrepreneurs and across smaller towns and cities.

Their smaller size may also be helping, but these companies are aligning themselves with emerging trends better than some of the larger businesses. During the latest quarter, mid-cap earnings grew faster than large-cap earnings, while small-cap earnings grew faster than mid-cap earnings.

In my view, this is not a market of large caps, mid caps and small caps. It is a market of growth and no growth.

As a general principle—and this is only my view—if a company’s earnings cannot compound at more than 15% over a three-to-four-year period, no valuation necessarily makes it attractive. Investors enter equities for growth. There is no scientific basis for the precise threshold; I am simply using 15% as the bear-case growth rate that investors should seek in India.

If the market offers companies capable of compounding earnings at 25%, 30% or 40%, as we are seeing among several small- and mid-cap companies, investors will tend to value them at a premium to large caps. That is what is currently happening.

Retail investors can invest relatively small amounts in companies with market capitalisations of ₹5,000 crore or ₹10,000 crore. Are institutional investors missing these opportunities because of limited size and free float?

The primary market, through initial public offerings, qualified institutional placements and block deals, is providing institutions with adequate room to deploy capital in areas where they have conviction.

If the primary market were not vibrant, deploying capital would have been a challenge. Look at the number of IPOs and the amount of primary capital being raised. One can be concerned that too much supply is arriving at once, but if investors have conviction, deals provide an effective route for making allocations.

That applies across pre-IPO, IPO and post-IPO transactions. The supply of shares coming through deals is broadly matching the buying taking place in the market. Investors can therefore deploy capital in mid- and small-cap companies, although they need to build conviction and may have to pay a premium.

Foreign investors have also shown buying interest in mid- and small-cap stocks over the past few quarters. Is that trend sustainable?

Foreign institutional investors are realising that India must be approached through growth, and generally through high growth, because they have investment options across the world. An Indian investor has relatively limited alternatives, while global investors can move money between countries based on portfolio allocation.

Their approach to India has become highly bottom-up. They are looking for companies where earnings can not only compound but potentially double or triple.

Foreign investors assume additional currency, price and regulatory risks when they enter a new country. In their home market, particularly the US, everything is denominated in dollars and several large companies are already growing at 20% to 30%. To invest in India, they therefore require substantial growth.

That growth is available among mid- and small-cap companies. Consequently, foreign investors are moving out of some large-cap stocks and into mid- and small-cap companies. I do not see that trend changing in the near future.

The size of small- and mid-cap companies has also increased, even though their formal definitions have not changed. Does that make institutional participation easier?

The 100th-largest company in India today has a market capitalisation of approximately ₹1.1 lakh crore, or about $11 billion to $12 billion. The company ranked around 250th has a market capitalisation of roughly $4 billion to $5 billion. Those are meaningful sizes.

Investors may always want more liquidity, but free float is also increasing as these companies grow and undertake additional capital raisings.

We recently handled the LIC offer for sale, which was roughly ₹32,000 crore and the largest ever. It was significantly oversubscribed, and investors have made money from the price at which the transaction occurred. India is offering substantial quantities of shares in companies where investors can deploy capital with conviction.

Which sectors within the broader market appear attractive?

From a research perspective, the opportunities can be divided into several categories. Financials remain the bedrock of the market. Credit growth is close to a multiyear high of 19% to 20%, which is a highly favourable environment for lenders.

The capital-markets ecosystem is also transforming. India now has several listed asset-management companies, wealth-management firms, brokerages and registrars. Five years ago, the sector had limited market representation; today, it has become a proper investible segment, and I expect it to continue growing. It represents another dimension of India’s consumer story.

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So would you classify capital-market companies as high-growth businesses or compounders?

They are compounders with strong growth. These businesses are not growing at 10% to 12%; they are growing at 20% to 25%. Compounding at 20% to 25% warrants a different level of valuation premium.

Automobile companies are also performing very well, and the momentum in volumes has continued following the goods and services tax reduction. Even after the festive season, volumes remained strong.

But will the favourable base effect for automobiles eventually fade?

Investors need to focus on absolute volumes, which are still growing well. If automobile companies can deliver low-double-digit growth even on last year’s high base, the market will respond positively.

Selected discretionary-consumption segments are also recovering. Quick-service restaurants performed well during the quarter, while jewellery continues to do very well. Investors need to identify the pockets within discretionary consumption that are delivering strong growth.

The latest quarter was strong across companies ranging from Burger King to Devyani International. Jubilant also provided encouraging guidance. These companies had experienced two to three years of very low growth, so this appears to be a comeback segment.

Valuations in the QSR segment were also relatively inexpensive.

These are businesses where, if growth returns, investors will participate in the cycle. Valuations can appear cheap or expensive depending on how they are assessed. Some of these segments should be evaluated primarily on growth rather than through an inflexible valuation threshold.

Several automobile-component manufacturers have diversified into aerospace. Is that a natural extension of their capabilities?

It is a natural extension. Once a company develops a competency, its growth trajectory depends on how many additional business lines it can build around that capability. That ultimately determines the size the company can attain in the years ahead.

Aerospace is still a relatively new industry in India, but it could become very large. Electronics manufacturing services was also a small industry five to seven years ago. Some companies subsequently built capabilities and manufacturing scale, and today several have market capitalisations ranging from ₹15,000 crore to ₹50,000 crore, with the potential to grow further.

The market is currently taking a leap of faith that the opportunity available in some of these sectors is substantial and that certain companies have developed the capabilities required to benefit from it. Once that happens, earnings should follow. In several areas, valuations reflect an underlying belief that long-term growth could be significant.