Why investors may be ready to return to large-cap stocks

Mutual fund investing has rarely followed a more inverted pattern than it does today. Capital has persistently chased small-cap and mid-cap funds, with money flowing largely one way into these categories through lump-sum investments. Investors have shunned bluechip-heavy large-cap funds, while incremental growth in the SIP book has also come largely from small-cap and mid-cap categories. The prevailing belief was that large-caps could no longer deliver the growth potential of these emerging categories.

Strong inflows certainly helped small- and mid-cap stocks show strength and resilience for several quarters. However, two factors have changed the picture in recent months: a sharp spike in commodity prices and the significant valuation premium at which these market favourites trade relative to the rest of the market.

Discerning investors have begun trimming positions in overvalued stocks, while selling pressure is rising rapidly in companies that show even the slightest disappointment in quarterly results. Investors are also factoring in the impact of sustained commodity inflation on future demand, sales growth and margins.

At the same time, the sharp contraction in large-cap valuations has significantly widened the gap between these companies and the market's favourites. This has made investors more conscious of the relative attractiveness of large-caps, given their discount to historical valuations, strong ability to revive growth and superior balance sheets. These companies also have the capacity to reduce their capital base through share buybacks.

The prospect of management teams initiating buybacks, even amid investor apathy, is real. We are also seeing preferential issues in which promoters are buying shares in bluechips. Bajaj Finance is a prime example. In much-hated sectors such as life insurance, promoters are raising their stakes at historically low valuations; ICICI Life is one example.

There are several signs of management teams and boards stepping in to signal confidence in companies even as the market overlooks their merits. Yet, this confidence is still not translating into broader investor interest. The bias against large-cap investing remains strong, with investor aversion at a historic high.

Early signs of rotation

But the tide could be turning, although it may still be too early to call. For starters, the sharp correction in September and October has reopened the debate over whether blindly buying small-cap funds at any valuation can continue to work.

The lack of growth in the large-cap space, coupled with relentless selling by foreign institutional investors (FIIs), continues to keep the broader segment weak, weighing on performance and sentiment. Meanwhile, mid-cap and small-cap fund performance has also begun to weaken this results season.

Companies held by these funds are being punished when they fail to meet stretched investor expectations. Stocks are seeing sell-offs even when quarterly performance is reasonable. Those reporting earnings disappointments are suffering sharper drawdowns as investors rapidly unwind positions they once held with conviction.

This erosion of investor conviction is sending a broader warning to those bidding up IPO prices on listing and buying into companies reporting strong quarterly results during a favourable earnings cycle.

At the same time, falling valuations in already cheap companies are creating contrarian buying opportunities in several bluechips, although the buying remains sporadic and selective. The recent rally in IT stocks is a good example of how confidence can return to a sector that was widely disliked and had seen a sharp correction.

The growth question

The road to recovery, however, will be slow and painful, and investors will have to climb over a wall of fear. Still, the market mood suggests that fatigue with expensive segments such as small-caps and mid-caps could trigger a rotation towards attractively valued large-cap companies.

The sharp rebound in bluechip IT stocks could spread to other beaten-down sectors where valuations have become difficult to ignore. The main factor holding back this rotation is uncertainty over when growth will return in sectors such as consumption and pharmaceuticals, or when net interest margins and return on assets will expand in banking and financial services.

As visibility improves, more factors providing directional confidence will emerge. As investors grow more sceptical of overvalued companies, opportunistic capital could begin moving towards businesses where value is more evident. Even small positive developments would start attracting greater investor attention, while relatively minor negatives may be overlooked.

Investors would gradually begin bargain-hunting for value in bluechips. Slowly, the wheels of the market would start turning.

For now, investors have only begun rethinking their aggressive investment stance, prompted by weakness in overvalued stocks. The remainder of the results season could accelerate this reassessment. Mutual fund investors may need to review their portfolios and reposition them before the tide turns decisively.

Shyam Sekhar is chief ideator and founder of ithought Financial Consulting LLP.