Kotak puzzled by broad-based market rally, seeks clarity on outperformance of midcap, smallcap stocks

The brokerage house has reduced its weight in certain consumer sectors and trimmed positions in banking stocks

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Kotak Institutional Equities, in its latest report, acknowledged the broad-based rally but is uncertain about the reasons for the rally and the divergent performance across sectors. The brokerage house also does not see any specific reason for the recent surge in midcap and smallcap stocks.

Kotak highlights that India’s weak consumption demand should have had a negative impact on smaller companies, as recent commentaries from companies show no signs of improvement. On the other hand, improved macroeconomic indicators, such as lower inflation and current account deficit (CAD), should have been more favourable for the performance of large-cap companies, aligning with the positive top-down view of India among foreign investors.

Kotak also said that the certain sectors in the midcap and smallcap space deserve a re-rating. These include smaller private banks, healthcare services (hospitals) and real estate, it said, as they had reasonable valuations prior to the rally and exhibit a strong outlook. On the other hand, it was challenging to understand the rally in smaller consumption and IT services stocks, the brokerage said. “This is particularly puzzling considering the ongoing weak domestic demand in the consumption sector and the diminishing global demand for IT services,” the report said.

“(The recent rally) has resulted in rich valuations for the consumption and investment sectors versus history. Most stocks in these sectors are trading at close to or above our 12-month fair values. Valuations of outsourcing sectors may look reasonable versus history but the IT services sector faces both short- and medium-term challenges. Valuations of most BFSI stocks are still attractive despite the recent run-up in insurance stocks,” said the Kotak report.

The brokerage warns that, post the recent rally, headline valuations may be misleading. “While the current valuations may not seem overly expensive when compared to recent historical data and bond yields, the overall valuations may be held back due to the undervalued banks that heavily contribute to the overall profits of the headline indices. We find that valuations are quite expensive in most cases, especially when considering past valuations supported by low global interest rates. Additionally, the failure to account for future disruptions further reinforces the perception of expensiveness,” the report added.

Cut in positions
Kotak Institutional Equities has reduced its weight in certain consumer sectors and trimmed positions in banking stocks. The brokerage house said it was having trouble identifying investment opportunities within the consumption, investment and outsourcing sectors due to the recent surge in local equities. Despite this struggle, the BFSI sector stands out as the only sector currently offering value, it noted. However, even within the insurance segment, stock prices have experienced notable rallies in the past few days, Kotak said in its latest report.

The brokerage house has reduced its weightage for Britannia Industries by 40 basis points (bps) to 150 bps; for Godrej Consumer Products by 20 bps to 150 bps; and for Titan Company Ltd by 30 bps to 200 bps. Kotak has also trimmed its positions in banks, reducing its weightage by 30 bps to 750 bps for Axis Bank, and by 30 bps to 150 bps for non-banking financial companies (NBFCs).

It also added InterGlobe Aviation (parent of airline IndiGo) with a weightage of 150 bps while dropping Narayana Hrudayalaya from its recommended large-cap model portfolio. According to Kotak, IndiGo presents a potential upside of 22 percent in relation to its 12-month fair value estimate of Rs 3,000. Currently, the stock is trading at 13 times the estimated earnings per share (EPS) for fiscal year 2024 and fiscal year 2025. However, the brokerage house acknowledges the potential volatility of Indigo’s earnings, which can be influenced by various external factors.

“For now, we draw comfort on a rational domestic market structure (consolidating in favour of IndiGo) and muted global oil prices,” Kotak said in its report.

The brokerage house says that despite having favorable fundamentals, Narayana Hrudayalaya is currently trading higher than its 12-month fair value of Rs 905. While Kotak continues to hold a positive view on the company’s underlying fundamentals, it acknowledged the stock’s expensive valuation and anticipates relatively flat earnings and modest EBITDA growth between fiscal years 2023 and 2025.