You have a very wide universe of stocks which you track among all the brokerages and it is only becoming wider. A lot of midcap and smallcap stocks are represented in your universe. The entire argument that smallcap, midcap rally so far was not broadly justified and there was frothy valuations and earnings. What is the reality of the earnings? What part of the smallcap, midcaps are showing strength in earnings and which part is actually falling back?
Gautam Duggad: It is always very simplistic to paint the market or any segment of the market with one brush. You will find froth even in a bear market in some segments and even in a bull market you will find value in many segments. Secondly, when it comes to mid and smallcaps, you have been in the market for a very long time. The one deciding factor always in mid and smallcap specifically is the bottoms-up thesis. You really cannot take a top-down macro view, especially in midcaps and smallcaps, so that is one point.

Second, I agree that valuations are expensive for mid and smallcaps, but it is not correct to say that the entire mid and smallcap basket is frothy. Allow me to explain that. Midcap index right now is trading at around 30% premium to Nifty. Nifty is trading at close to 19-19.5 times one year forward now and midcap index is trading at somewhere about 27 times which obviously is very expensive.

Smallcaps are also trading at expensive valuation at an index level. Usually the average of smallcaps, if you look at the comparison versus Nifty on a 10-year basis, the long-period discount is about 24%. Against that 24% discount, today it is trading at a 10% premium to largecap. So, clearly, when you compare at an index level – and we use NSE midcap 100 and NSE smallcap 100 when we do comparison of these baskets – definitely things are expensive.

There are some segments within mid and smallcaps where things have run away far ahead of themselves as far as fundamentals are concerned. A few of the industrial names as well as PSU names have earnings and cash flow support. But that is the nature of the market. In any bull market, we will always find some things are getting too expensive and frothy and some things are always available where you can still justify, for example, that the domestic cyclicals like hotels, real estate, some of the consumer discretionary names where the earning support is very strong, are the spaces where money can be made.

In fact, we just concluded our midcap conference this week, Monday and Tuesday. We had about 80 companies which were part of this conference. This is our ninth annual ideation conference. Across sectors, companies were represented and we had about 60% of those companies being represented by CEOs. Now, the point is, given the recent correction in mid and smallcaps, we have seen huge interest in meeting those companies from the institutional investor’s side. So, where you basically stand depends on where you sit and when you look at the composition of the market. Today we are talking about 4.5%, 4.6%. I do not know the exact number right now because since last week, things have changed. The total market cap in India presents a lot of opportunities at any given point of time for a bottoms-up investor.What were the takeaways from the conference, the buzz and talk around PSUs? Some believe that it is getting frothy out there, but given that India has a decade-long story, I am sure every correction is also a buying opportunity?
Gautam Duggad: Yes. I mean, if you look at the last 10-15 years in India, we have not seen any big durable market correction. Whatever episodes of market correction that we have seen, be it in 2013, 2018, and 2020, they were very short and swift. At least so far, it has paid in the last 10-15 years to buy the dips and to invest for the long term.

Now, as far as PSUs are concerned, the PSU index of BSE was flattish from CY12 to CY21, that is almost nine years. The total earnings pool in that nine years was also flat. In fact, in CY21, the BSE aggregate earnings were down compared to CY12. Now you look at the current year. In the current year, the BSE PSU index is up somewhere close to 90%. But look at the earnings pool of the entire PSU basket.

If I look at FY18, the total earnings of PSU were about Rs 80,000 crore, which was the bottom in the cycle. From FY18 till FY23, the earnings went up from Rs 80,000 crore to Rs 3,80,000 crore. In the first nine months of FY24, already Rs 4,00,000 crore of earnings have been delivered. As a consequence of that, the BSE PSU index PE is still at 11 times. Now, one can argue that the same PE used to be seven-eight times and now it is 11 times and, of course, index PE always is a bit misleading because it hides a lot of things, because there are too many companies in an index and some companies will be expensive, some will be cheaper.

The point is, at an index level, when it comes to aggregate PSU basket, at 11 PE, I would not call it a bubble or a froth. Now, are there some companies which have run too far ahead of themselves without any earning support, the answer is yes. But are there still companies which are available at decent valuations, good dividend yield support, and decent earnings growth? Again, the answer is yes. So, it is a very complicated kind of a situation where some companies are very expensive even within PSU, some are still value buys.

In fact, if you look at our model portfolio, you will find there are five-six PSU names, so we have been very positive on PSU banks for the last two years. We have the highest overweight on PSU banks in our model portfolio since April 2022 and still the banks that we have in our model portfolio are trading at one time and 1.2 times price to book despite having doubled or tripled and we think that the next two years, the earnings are still going to be very decent and healthy for the set of PSU banks that we have in our model portfolio.

So, you have to dig deeper. You have to look at a lot of things, how the BSE PSU RE, the index ROEs look, how has the cash flow been. It is very simplistic to say that based on few stocks, the entire basket is frothy. I beg to differ there.

One clarification. When you say aggregate PSUs, you are talking about all the PSUs, metal, mining, power, PSU banks, everything into one or you are talking about non-banking PSUs put together?
Gautam Duggad: No, no, I am taking everything.

And which index were you referring to after this kind of performance on earnings?
Gautam Duggad: Yes. Like I said, for nine years, earnings were flat. Nine years, the index has done nothing. The index has started doing well only in the last 12, 18 months, while earnings have bottomed out in FY18. You can obviously dig deeper even there and you will see that the incremental earnings between FY18 and FY23, 50% of them came from a single sector, which is PSU banks.

The next 30% came from metals and oil and gas. Then the rest of the 20% from all other PSU sectors put together which is utilities, defence and everything else. The banking cycle, including the PSU banking cycle changed in FY18. If you look at the Nifty financials, there were 11 financial companies in Nifty and there are still 11, maybe 10 now after the merger of HDFC. If you look at the aggregate profit pool of these 11 companies back in FY18 in Nifty only, their profit used to be 45,000 crores.

Now, as we are about to close FY24, they are at about Rs 2.5 lakh crore and next year our expectation is that the only financials part of the Nifty, their total profits will be Rs 3 lakh crore. Now, Rs 3,40,000 crore was the profit of the entire 50 Nifty companies in FY20. Five years later, that is FY25, we are talking that just the 10 financial companies will have that Rs 3 lakh crore profit pool.

So, the profit picture in India has changed considerably. Without bothering you too much with numbers, let me tell you one more number. In FY20, the total profit of Motilal Oswal coverage universe was Rs 4,28,000 crore. As we are about to close FY24, the total profit has moved to Rs 11 lakh crore, that is a four-year earnings compounding of 27%. The equivalent number for Nifty 50 on a four-year basis is 22%.

Look at the performance of the index, it broadly tallies with the underlying earnings growth. Obviously, within the index, some sectors would have done better, some would have not done as good as others. But the point is, broadly, the market has respected the underlying earnings growth. When earnings were tepid for 10 years between FY10 and FY20, the market was also tepid. You got 8.5% return in Nifty in that 10-year period when earnings compounded at just 6.5%. Last four years, earnings have done well, so markets have also done well.