Focus On Local To Mitigate Global Conflict Risks, Says Motilal Oswal's Prateek Agrawal

Prateek Agrawal: As long-term investors, the lower the better. That said, but you know, we were actually deliberating on the same. If you look into what goes into valuations, it is not the size of the company. It is basically, the growth of the company in cash flows and the discount rate that one applies. Now, the big change is that, after 2020 bottom of Covid the small and mid have seen earnings growth, which is significantly higher than large. Now ballpark percent higher earnings growth should result in 2% higher valuations of a particular space. Hence we say that if the growth delta of mid and small continues to be significant versus large, the premiumness should sustain. Yes, the riskiness associated with this space on account of lower liquidity remains. So that's the risk that you are taking versus a more liquid, generally speaking, large-cap space. But, you know, for a 5% growth delta—that we believe could sustain going forward given that this is a whole new ecosystem coming up in many, many spaces versus earlier when these spaces used to trade at a discount to large cap—the thought is that it could continue to trade at a premium to large cap. The only thing is the growth delta should continue to sustain.

Prateek Agrawal: My short answer is, yes. If you are a long-term investor, you know, don't come into this space for momentum. But if you're a long-term investor, then this space should see earnings growth way higher for the same reason that you are saying you know, many of the growth themes are predominantly present here.

So longevity of growth is here. A lot of new businesses, new business lines are coming up, something which wasn't there in the country, let's say 2-3 years back. So all of them present in this space, longevity of growth is there. So, if you're a long-term investor, this is the space which should continue to deliver alpha.

Prateek Agrawal: Let's look at this period from 2000 to 2021 and beyond. Now, 2000 to 2008 is one period, 2008 to 2021 is the next period. Now, I'm not taking the bottom of Covid, which is 2020. I'm taking 2021. And 2021 and beyond is another period.

Now, if you look at 2008-20, the large-cap index earnings growth was 5%, you know, ballpark. Mid caps, you thought would grow faster than large, but actually the earnings growth of the mid-cap index was 4% and that of the small-cap index was 2.8%. So this was a period, which saw a lot of disruptions, for various counts and we all know that. I mean, starting from Leeman and ending with Covid. In between taper tantrums, etc, etc. Now, the highest quality part of the market, you know, let's take a consumer index, delivered earnings growth in this period at 12%. So this is the highest quality part of the market and incidentally in this very long period also delivered the highest earnings growth. Now that has changed. So, the index itself, after 2021 has been growing earnings at a clip beyond 20% and even in the last quarter, it was 17%. And even one assumes that consumers continue to do what they were doing, they are now delivering earnings growth significantly lower than that of the broad index itself. So they're no longer the growth leaders. It is the key thought for some space which has done so well over 13-14 years. It takes the connotation of quality did very well, quality does very well. It may actually be that growth did very well. Growth always does very well. In this 2008 to 2021 period, the highest quality part was also the highest growth part. That is not the case in 2021 and beyond period, wherein all of these newer spaces have come up. They are delivering growth vastly in excess of the index itself and index itself is delivering earnings growth which is higher than let's say the consumer part of the market. I'm using consumers repeatedly just to say that this is the highest quality part in the market as measured by an indicator like return on capital employed.

So, if one holds the thought that earnings growth is where markets ultimately go to, it went to the highest quality part in 2008 to 2021. For example, a 12% compounding of earnings in a consumer index ended up with a 15% compounding of the index itself. And now, when the Nifty earnings is higher than that of consumer the opposite is true. When mid-cap and small-cap earnings is higher than Nifty itself, those are doing better. This is one.

Second, continuing on the first question that you asked me—in the 2008 to 2021 period, there was no period wherein the mid and small had consecutive years of growth, three consecutive years of growth were not delivered. Both mid and small had one instance of two consecutive growth years. So you know, you start to look at a space, you make up your mind to go there and by the time moneys get positioned there, the earnings growth simply evaporates. So, you know, and when I speak a lot of what happened in that period would come back to the fore. You actually saw a bet in the mid and the small-cap space hurt you massively in that period.

Now, from 2020 onwards—if one takes 2020 as base of Covid—you got four years of increase in earnings, which is what is feeding into sustained performance of this space. Just one quarter is left in 2024. Mostly it will be a good nice growth over 2023. So if growth sustains, I think valuations and performance should come. By the way, the highest quality part didn't perform in the 2000 to 2008 period.

What are the similarities of the current period with 2000 to 2008? Before 2000, you saw a burst of reforms. From 2000 to 2008, you saw capex-led growth. You know, gross fixed capital formation increased for eight years from—if I remember right—2.7 as a percentage of GDP to 3.5%. The start point again is very similar. We have seen three years of growth, we had a huge dollop of reforms just before and they continue. So we should have at least four or five years more of capex-driven growth going forward.

Now in 2000 to 2008 again, this highest quality part didn't perform, if one takes the consumers part of the market. Hence we believe the same could be true in this period as well. Now, the key difference is, 2000 to 2008 was a period of debt, which hurt companies hell of a lot in the post-Lehman period. This time around the part which is doing well has a very sustainable level of debt, if at all. You know, 30% debt equity or lower is the usual thing that one experiences. So in many cases, in many ways, in this period, the mid and small are not what was the case earlier.