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Froth in small, mid-cap space has to be corrected; be very selective in IPO, says Arun Malhotra of CapGrow Capital Advisors

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A large number of unknown companies, with zero activity and questionable corporate governance, are seeing their stock prices soar. The higher they go; the bigger would be the sell-off and the dent they make in individual portfolios. We have already started seeing some corrections in the small and midcaps space, said Arun Malhotra, Founding Partner & Portfolio Manager, CapGrow Capital Advisors LLP.

After a decent outperformance recently, the small and midcap stocks are now witnessing a sharp sell-off. There is froth in the small and midcap space that has to get corrected and investors need to be very cautious in this space, says Arun Malhotra, Founding Partner & Portfolio Manager, CapGrow Capital Advisors LLP.

Speaking to CNBCTV18.com, Malhotra said that the trends in the primary market were very unhealthy as knowledgeable investors are exiting while the less informed investors are entering lofty valuations.

Here's what he said on the markets, economy and his advice to retail investors.

The markets are at all-time highs. What are the factors driving the rally?

The markets are factoring in the optimism due to the higher vaccinations that will help restore economic activity post the 2nd Covid wave. The large caps are now doing well, catching up with the underperformance of the last six months while the small and mid-cap space is seeing a correction. There is a lot of liquidity that is chasing equity markets.

There are concerns over elevated valuations. Can we see a correction going ahead?

The valuations are definitely not cheap. Rather we believe the small and midcap space is due for a sell-off.

What should be the strategy in the broader markets in this scenario?

Trade is to switch from small and mid-cap space to large caps. The large caps have not participated in the last six months rally and still offer decent upside. There is froth in the small and midcap space that has to get corrected.

A large number of unknown companies, with zero activity and questionable corporate governance, are seeing their stock prices soar. The higher they go; the bigger would be the sell-off and the dent they make in individual portfolios. We have already started seeing some corrections in the small and midcaps space.

 The second Covid wave saw only select lockdowns and the manufacturing and few other services were functioning normally, while the first wave saw complete shutdown barring few essential services. However, the second wave was more spread in tier 2 and tier 3 cities and there were a lot of small businesses and families that got impacted. This will have an impact on their consumption pattern in the short term.

Investors, especially, retail have made a good amount of returns in the last 15 months, as reflected in higher retail volumes, higher SIPs and the huge number of Demat and trading accounts being opened. Most of these retail investors are extrapolating these returns in the future and is a cause of concern. We feel the returns may be subdued going forward.

What is your take on Q1 earnings? Will we see upgrades going ahead?

Q1FY22 earnings were a mixed bag across the sectors. While IT continues to do well based on strong deal momentum and driven by a very strong demand environment, banking (incl. NBFCs) saw weak earnings driven by higher provisioning.

Pharma was a big let-down mainly due to pricing pressures in the US generics market. Metals and other commodities saw record profitability and that has helped them deleverage their balance sheets. Cement saw good numbers while Automobiles sales were down.

Two months of reduced economic activity have taken a toll on a large number of companies across various sectors. As we speak today, the majority of the companies have seen restoration to 90-100 percent of pre-Covid economic activity. And with the festive season coming, we should see some pent up demand helping companies post better numbers in the second and third quarters.

The primary market is in full action with plenty of IPOs in the pipeline. What should one look for before investing in an IPO?

The IPO market is hot right now with so many IPOs lined up. Our sense is that lot of them are at the extreme end of valuations on all metrics. One has to really extend the future and predict a rosy scenario for them to be justified at these prices.

Another indicator is a lot of smart investors (PEs and owners) are exiting through the OFS route, and few of them have been investors only for a short duration in these companies making extraordinary returns. The retail investors and HNIs through leveraging are seeing huge participation in order to make quick gains in the short term.

These are very unhealthy trends; knowledgeable investors are exiting while the less informed investors are entering at these lofty valuations. One has to be very very selective while investing in these IPOs.

Market dynamics have certainly changed now and the talks of QE tapering are going to play out in the near term. What asset class do you think should gain momentum in the event of the Fed deciding to wind up the balance sheet?

We believe the Fed has to act sooner than later. The US has already slowed down the bond purchases and QE tapering will slowly happen. The US markets may also see a rise in interest rates in another 6 to 9 months.

US equity markets are on the upswing and the valuations for a lot of technology companies are now justified on revenue multiple rather than earnings-based.

The recent hotbed of raising money through SPAC is highly questionable and insane. We believe fed measures will lead to a fall in US equities and could also be the trigger for the rest of the world markets to come down.

Going ahead, which sectors do you prefer - growth or cyclical stocks? What is your preferred asset class and why? Your advice to investors.

Our preference has always been towards equity as an asset class. Equities always provide the best risk-reward and the opportunity to create tremendous wealth in the long run. Equities have outperformed all asset classes- whether it is bonds, real estate or gold and by a decent, 2-5 percent margin over longer periods of time. That extra return when compounded over longer periods can create significant wealth.

We are primarily a growth-oriented investor but also play distressed situations (value stocks) across the economic cycles. Our advice to investors is to be cautious in the small and mid-cap space, and very selective in IPOs, while continue to be patient and a long term investor

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If you don’t stay with your winner, you are not going to be able to pay for the losers.

- Jack Schwager