Over the past two months, in four separate columns, I have highlighted the significant slowdown in the Indian economy which is now clearly reflected in the stock prices of major sectors such as passenger cars, consumer goods, banks, financial services and infrastructure. The two key market indices, the NIFTY and the Sensex, peaked on 27th September and have, since, shown little momentum. A sharp two-day rally, a day before and after the Maharashtra elections, was seen as a lucky break for the foreign institutional investors (FIIs) to resume their selling. While each such wave of selling will be countered by some buying, the bullish fervour is missing. The traditional year-end rally is due, especially since the past two months were dismal. But there is a more intriguing aspect of the market, hidden behind the NIFTY moves.
Between 27th September and 29th November, the NIFTY is down 8%. However, amazingly enough, both the NIFTY and BSE Smallcap indices were down only 3% and the Nifty Microcap dropped a mere 2%. This is unusual. In a bull market, smaller companies, typically, outperform their larger counterparts. But in a downturn, smaller companies usually bear the brunt of the losses. This time, that is not the case. What explains this anomaly?
Investors are optimistic about smaller companies for a reason. The heroes of India’s growth over the past four years have been smaller, efficient companies in green energy, electrical equipment, defence, healthcare services (hospitals and diagnostics), a variety of manufacturing sectors, infrastructure including railways, consumer technologies and retail financial services including wealth management. The new sunrise sector such as electronics manufacturing services (EMS), recycling, smart metering and data centres are dominated by small companies.
These hot sectors are not represented in the indices in any manner, except partly through one company Larsen & Toubro (L&T) which has been a surprisingly tepid performer. The NIFTY and the Sensex consist of big banks (stable but hardly growing), consumer companies (not growing), software companies (average growth in single digits) and commodity companies, some of which are from the public sector. All these sectors are struggling against the headwinds of sluggish demand.
Bank credit is not growing because companies are still focused on deleveraging their balance sheets, while higher interest rate cost is squeezing the net interest margins of banks. Meanwhile, the stock market is more than willing to fund any reasonably promising growth story, making equity capital far more attractive than bank credit. Consumer companies are grappling with weak demand, driven by stagnant income growth among the middle class and below. Software companies get growth boosters mainly with disruptive cycles such as dotcom, back office automation or banking software and finance operations.
The last significant cycle was driven by the adoption of technology to manage the challenges posed by COVID restrictions on companies, employees and consumers. It remains uncertain whether the current artificial intelligence (AI) boom will benefit or disrupt Indian software companies. Note that the five-year compounded annual growth rate (CAGR) in profit of Tata Consultancy Services was just 8%. The only bright spot in the NIFTY and the Sensex are pharmaceuticals companies, although the fastest-growing ones are outside these indices.
This tells us why index stocks are not a very exciting place for investors. They comprise businesses that are easier to understand and their market liquidity is high; foreign portfolios are full of them. But they pale in comparison to smaller companies which, today, come from an array of sectors mentioned above. They form the second and far more dynamic market which is eclipsed by the headlines made by Nifty behemoths.
For example, a small engineering company based in Indore, with a market-cap of just Rs4,000 crore, exports 65% of its output and has notched up a 54% CAGR growth rate in net profit over the past five years. A pharmaceutical company, which avoided the beaten track of rushing into Western markets and concentrated on South America, has recorded CAGR in profit of 42% over ten years.
India’s biggest listed EMS company has recorded a CAGR in profit of 39% in 10 years. Its market-cap is pushing Rs1 lakh crore. I can give scores of such examples. The contrast between these and the Sensex giants is hidden from plain sight. Will these companies keep growing?
Often, it is the economic policies of a government that drive corporate growth.
The policy of the past four years has been massive government capital spending on infrastructure, defence, railways, etc, and support to local manufacturing through production-linked incentives. These initiatives have had a tremendous effect on small companies. Even a tiny fraction of the Rs11 lakh crore direct government spending or spending encouraged by government policies, coming the way of some small companies, can propel their businesses into a whole new trajectory. This is exactly what has happened to companies in green energy, electric transformers, smart metering, water management, railway equipment, etc.
However, many other top-performing smaller businesses have nothing to do with government policies. They come from sunrise sectors such as hospitals, EMS, drug research and manufacturing, consumer technology, outsourced business services, financial services, market infrastructure companies and even some older traditional businesses like light engineering and automotive components. The top-performing companies in these sectors have a tailwind but are also run by focused and driven managers, hungry for growth.
There is an interesting corollary to all this. By a curious set of coincidences, most of the non-promoter shareholding of these small companies is with retail investors, some of whom have been plainly lucky to be at the right place and time. A small number of young, smart investors have done their homework and diligence to catch the trend too. Only a few of these stocks are in the portfolios of mutual funds. The boom has bypassed big institutional investors who stayed focused on India’s sluggish consumer economy and software stocks. This probably explains why when the NIFTY falls on FII selling these days, smallcap and micro-cap indices do not drop much. It is a phenomenon never seen before, along with many other wonders of the Indian stock market that we have been witnessing since COVID.
(This article first appeared in Business Standard newspaper)
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