ETMarkets Smart Talk | Earnings growth, ROCE and cash flows are key to identifying future wealth creators: Aditya Khemani

ETMarkets.com

While India’s manufacturing sector could offer significant opportunities, investors must also distinguish between companies with strong fundamentals and those whose valuations already factor in lofty growth expectations.

Return on capital employed (ROCE) and operating cash flows are equally important indicators of whether a business can scale sustainably and create long-term value.

While India’s manufacturing sector could offer significant opportunities, investors must also distinguish between companies with strong fundamentals and those whose valuations already factor in lofty growth expectations.

In this episode of ETMarkets Smart Talk, Aditya Khemani, Head – Equity at Invesco Mutual Fund, discusses how investors can identify potential long-term compounders, why earnings growth, ROCE and cash-flow generation must go hand in hand, and the financial red flags to watch out for in small- and midcap companies.

He also shares his outlook on market leadership, the long-term potential of mid- and smallcaps, and the opportunities emerging from India’s manufacturing push. Edited Excerpts -

Q) Thank you for taking the time out. Mid-and smallcap funds have outperformed largecaps over the past year, but valuations appear to favour largecaps. Is this a potential turning point in market leadership?

A) Over the last year, the Nifty 100 TRI Index has declined by around 7%, while the Nifty Midcap 100 TRI Index has remained flat and the Nifty Smallcap 100 TRI Index has gained around 6%. This indicates reasonable outperformance by the SMID indices relative to large caps over the past year.

However, let’s first look at the composition of the large-cap index. The top 10 stocks account for around 43% of the index weight, with the largest stock alone accounting for approximately 8.5%.

In contrast, the SMID indices are much more diversified, with the top 10 stocks accounting for around 16% of the Midcap index and 11% of the Smallcap index.

One key takeaway is that the performance of the large-cap index is heavily influenced by a handful of heavyweight stocks, unlike the more diversified SMID indices.

Of the top 10 stocks in the large-cap index, six are financials, together accounting for around 26% of the index weight, while the overall weight of the financial services sector stands at approximately 35%.

Broadly, large private sector banks look attractive, supported by steady earnings growth and inexpensive valuations. Additionally, the listing of a large telecom player has further strengthened the outlook for the telecom sector.

However, certain sectors within the large-cap universe, such as FMCG and IT, are likely to witness a relatively weaker growth trajectory.

So, while a closer look at the large-cap universe suggests that large caps could tactically outperform SMIDs as they catch up after a period of underperformance, we believe SMIDs will continue to remain an attractive segment of the market over the medium to long term, supported by stronger earnings growth.

Small-cap funds attracted ₹9,039 crore, while mid-cap funds received ₹7,835 crore in September. Given the strong investor interest, are valuations in these segments justified by earnings growth

SMIDs are a highly heterogeneous segment of the market, with different sub-segments exhibiting varying earnings growth profiles and valuation ranges.

There is also a degree of polarisation within the indices, with some high-growth areas backed by positive narratives trading at very expensive valuations, while other segments facing temporary earnings challenges due to various factors are available at attractive valuations.

One of the defining characteristics of the market today is the growing influence of earnings momentum on stock price performance. Strong flows into this segment have also led to FOMO in certain pockets, resulting in stretched valuations.

Additionally, the post-listing performance of recent IPOs, most of which have been in the small- and mid-cap segments, has prompted caution in some areas of the market.

Overall, following the recent correction, there are pockets of attractive opportunities. We believe this will continue to be a bottom-up market, where stock selection and portfolio construction will be critical to building a high-quality portfolio capable of delivering mid-teens compounding returns.

Q) Should investors continue their SIPs in small- and mid-cap funds at current valuations, or consider redirecting incremental investments towards large-caps and diversified equity funds?

A) We strongly believe that over the long term, the SMID segment will outperform large caps for several reasons.

First, as the economy grows, new sectors and opportunities continue to emerge. Small- and mid-cap companies are often well positioned to capitalise on these opportunities, providing investors with exposure to emerging growth areas.

Second, a company’s size plays an important role in its incremental growth potential. Given their relatively smaller base, SMID companies have greater potential to grow their earnings at a faster pace than large-cap companies.

Therefore, investors should consider maintaining exposure to the SMID segment while constructing a balanced portfolio aligned with their individual financial goals and investment horizons.

There is a growing talk around largecaps. Are largecaps becoming attractive because their valuations have corrected, or do they also offer better earnings visibility in the current market environment?

Q) You track small & midcaps very closely - how much of the future earnings growth of mid- and smallcap companies is already priced in? What would it take for these stocks to justify their current valuations?

A) As mentioned, the SMID segment is highly heterogeneous, with varying levels of attractiveness across different areas. Broadly, we can divide it into two categories: traditional companies and sectors, and emerging companies and sectors.

In traditional sectors, valuations are relatively well established, as historical multiples provide a useful reference point and earnings growth expectations may not differ significantly from past trends. Consequently, the range of potential surprises is relatively narrow, as is the range of possible investment outcomes.

Valuations in this category are therefore more reasonable, and, in aggregate, I would expect stock price compounding to be broadly aligned with earnings growth over time.

The second category comprises companies in emerging sectors, including many recent IPOs, where investor expectations can vary significantly. This is largely because investors have different views on the future earnings growth trajectory of these businesses, leading to wide variations in their valuations.

This segment is likely to produce both significant winners and losers, given the high earnings growth expectations embedded in many of these stocks. Investors therefore need to exercise greater caution, as several stocks may already be pricing in growth well ahead of what their fundamentals can justify.

Accordingly, portfolio construction in this segment requires a bottom-up approach, with a careful assessment of each company and the earnings growth it needs to deliver to justify its current valuation.

Q) For an investor starting a fresh SIP today, should largecaps form the core of the portfolio, with mid- and smallcaps playing a complementary role?

A) How one should allocate their money depends on their financial goals. While investors tend to compare returns, they often overlook their risk appetite, which can vary significantly from one individual to another. Both factors need to be considered when constructing a portfolio.

For someone just starting their investment journey and with no plans to withdraw their investments for at least the next 8–10 years, I believe small- and mid-cap funds could form the core of their portfolio, provided they have the risk appetite to withstand the higher volatility associated with these segments.

Over a sufficiently long horizon, say five years or more, their earnings growth potential could be higher than that of large caps.

Historically, over the long term, stock price compounding tends to broadly track earnings compounding, which reinforces the importance of investing in businesses with sustainable earnings growth potential.

Q) Where could India's next generation of small- and midcap wealth creators emerge from: manufacturing, capital expenditure, financialisation, healthcare or emerging technology businesses?

A) The SMID universe is broad, and when an economy is performing well, wealth creators tend to emerge across sectors. Historically, private equity has been quite active in segments such as financial services, healthcare and consumption, and we have seen several wealth creators emerge in these areas. We believe these segments will continue to produce winners going forward.

However, if I had to pick one additional sector, it would be manufacturing. Over the past 10–15 years, India has not performed as well as it could have in this segment.

However, the drivers of growth for Indian manufacturing have never been as evident as they are today. These include import substitution, indigenisation and India’s cost advantage in manufacturing compared with developed markets.

As a result, companies across sectors are increasingly establishing manufacturing bases in India, including Apple and businesses across the aviation and electronics ecosystems.

That said, we believe wealth creators will emerge across sectors, rather than being concentrated in any one particular segment.

Q) How important are return on capital, cash-flow generation and balance-sheet strength when evaluating small- and midcap companies? Which financial warning signs would make you avoid a stock despite its growth potential?

A) Irrespective of a company’s size, three key financial parameters for evaluating its performance are earnings growth, return on capital employed (ROCE) and operating cash flow.

While earnings growth tends to receive significant attention in the short term, the other two parameters are equally important. A healthy balance across all three is essential for a company to scale sustainably and eventually become a much larger business.

If a company falters on even one of these parameters, its ability to create long-term value could be compromised.

However, when evaluating small- and mid-cap companies, it is important to recognise that many are at an earlier stage of their lifecycle. Their financial parameters may not yet be fully optimised but should ideally improve as the business grows in size and scale.

Therefore, rather than focusing solely on absolute numbers, investors should assess the trajectory of improvement. If the company is moving in the right direction, that can be an encouraging sign.

There are several financial red flags to watch out for, including high balance-sheet leverage, weak operating cash flow generation, frequent capital raises to fund organic growth, lengthening working capital cycles, a high proportion of receivables outstanding for more than six months, and significant related-party transactions.

These are just a few of the financial parameters to consider. Investors must also evaluate qualitative aspects such as board composition, auditor quality and any pledging of shares by promoters.

Together, these financial and qualitative indicators provide a more comprehensive assessment of a company’s fundamentals and its ability to create sustainable long-term value.