Nitin Sharma, Director Research & India Site Head, Fidelity International, believes mid and smallcap space still has some quality plays and stock-specific investment is the right approach in the current market.

Sharma has more than 20 years of experience in the capital markets in varied roles such as analyst, portfolio manager, and research team builder and leader.

Any flareup in the fixed income markets can spook equities and lead to valuations coming off, particularly for companies with long-dated cash flows. India equities could remain volatile in the near term as the uncertainty over the pandemic and some of these global tantrums play out, he said in an interview to Moneycontrol's Kshitij Anand

Edited excerpts:

Q) The second wave is not yet over for India, and experts are already talking about a third wave. What is the kind of impact you see on markets, and earnings?

A) After the initial scare, the markets are slightly up from when the second wave hit India. The base case scenario for the market then appears to be a sharp rebound in economic activities post the second wave.

And, the wave itself is expected to be much shorter in terms of duration limiting the economic impact on India irrespective of the human cost we have had to bear.

With expectations of wider availability of vaccines, investors are putting in hopes for a relatively benign third wave, if any.

The above should limit the earnings impact largely to the current quarter, with resumption of growth from the next one.

Q) Small & midcaps have been resilient so far but given that most businesses are shut due to Covid-related lockdowns, do you think the outperformance can continue?

A) The Small and midcap performance over the last year or so has been driven by robust earnings. Cyclicals, including intermediate goods sector space, have driven this performance as these businesses have enjoyed a good pricing power.

If the wave two disruption tapers off by June, the outperformance can again be seen, particularly as the midcap valuation premium over Nifty has come off in the recent months.

Having said that, we always go by and recommend a stock-specific approach which is even more important at this end of the market-capitalisation.

Key risks for small and midcaps, in general, are margin pressure for select sectors owing to higher input prices, and a prolonged shutdown which will hurt companies with high operating leverage.

Q) From an FII perspective, how is India placed in terms of valuations when compared to global peers. Are we still attractive?

A) India has always traded at a premium to most emerging markets, which is still the case. Historically, this premium was justified based on both, a superior growth profile and a distinct Return on Equity (ROE) advantage.

However, the ROE advantage for India has gradually been coming off and is no longer that substantial. At the same time, the earnings growth, for example for FY22, is largely in line with most of the emerging markets.

Given these factors, India appears a tad expensive than its peers. China and some of the ASEAN markets are visibly cheaper.

One must, however, keep in mind the long growth runway India promises. There are several high-quality names with strong moats that will continue to attract global investors.

Q) Where do you see smart money moving in various sectors and why?

A) All money backed by a sound investment approach is smart money, and truly so if it is patient! Still, from a sector allocation perspective, preference is towards energy and materials (driven by the commodity cycle) and industrials.

Financials are being shunned owing to a distinct possibility of another round of bad loans, this time in both retail and SMEs.

Consumer discretionary is also seeing a decline in weights as there may be an inclination to savings till income certainty is truly back across the board.

Q) Lot of IPOs have hit the market so far in 2021 and many MFs have taken a big bite out of it. What are the factors which fund managers look at while investing in an IPO?

A) The core factors determining the attractiveness of any investment proposition remain the same irrespective of it being a primary or secondary market.

You want quality businesses with pricing power that can be scaled with relatively lower capital and have a good capital discipline. And of course, you want a good safety margin in valuations.

Most of the IPOs these days come with a good enough history of the business for investors to assess their track record. This lends well to a conventional business and financial analysis. Beyond that, it is important to understand the management’s ambition and vision, and the long-term structures they have put in place for the same.

Lastly, the objective around raising money is also important. Fund managers will look avoid businesses that are looking to ride the capital market cycle rather than being driven by core business needs and an inclination to form deep partnerships with the investors.

Q) What are the key risks to the current bull market? Nifty is down by about 5% from the highs – do you see more downside before things stabilise and why?

A) Beyond the Covid19 uncertainty, the key risk for the markets is the rising inflation expectations. US breakeven rate is now 2.6% indicating potentially rising interest rates.

While central banks will try to be as accommodative as possible and for as long as possible to support the nascent revival, they will still need to keep a watch over prices.

Any flareup in the fixed income markets can spook equities and lead to valuations coming off, particularly for companies with long-dated cash flows. The developments in the US and other global markets will also impact India, both from capital flows and business perspectives.

India equities could remain volatile in the near term as the uncertainty over the pandemic and some of these global tantrums play out.

Post that, though, the focus will be on the possible path to reviving the capex cycle and creating a sustained, multi-year earnings growth phase. The building blocks for the same are getting in place gradually.

Q) What are the key risks to the current bull market? Nifty is down by about 5% from the highs – do you see more downside before things stabilise and why?

A) Beyond the Covid19 uncertainty, the key risk for the markets is the rising inflation expectations. US breakeven rate is now 2.6% indicating potentially rising interest rates.

While central banks will try to be as accommodative as possible and for as long as possible to support the nascent revival, they will still need to keep a watch over prices.

Any flareup in the fixed income markets can spook equities and lead to valuations coming off, particularly for companies with long-dated cash flows. The developments in the US and other global markets will also impact India, both from capital flows and business perspectives.

India equities could remain volatile in the near term as the uncertainty over the pandemic and some of these global tantrums play out.

Post that, though, the focus will be on the possible path to reviving the capex cycle and creating a sustained, multi-year earnings growth phase. The building blocks for the same are getting in place gradually.

Q) According to the CMIE report, 11 lakh jobs have gone amid the rise in COVID. This will hit the economy and earnings of India Inc. Do you think this will put the banking and financial sector including NBFCs at a risk in the near term?

A) In many ways, this risk is already playing out. Public sector banks and several NBFCs are were grappling with a sharply higher restructured loan book and are now seeing the addition of retail loans to this pile as well.

Combined with expectedly sluggish credit growth, this is putting pressure on capital ratios for the weak operators. It is reflecting in the declining earnings expectations along with lower valuations relative to Nifty for the sector.

However, it will not be a uniform story. Well capitalised banks and those focussed on, for example, secure mortgage loans will use the current crisis to gain market share and could be worthwhile picks in case of any broad sector sell-off.

The quote was originally published in moneycontrol.com in May 2021.

The opinions expressed are author's own. Fidelity International is not responsible for the author's opinions.