Is The Rally In Small And Microcap Stocks Sustainable?

While the corporate sector has benefited from massive capital expenditure, leading to sky-rocketing stock prices, investors would do well to keep an eye on the macroeconomic picture and government finances, not just corporate profits, for signs of trouble, alerts Debashis Basu.

An extraordinary bullishness has gripped a segment of the Indian market.

While the larger companies are merely chugging along, the stock prices of smaller companies are shooting up like wild weeds for the sixth month running.

From early April, when the current rally started, the Nifty50 is up only 14.1 per cent while the Nifty500 has gone up 19.7 per cent.

Meanwhile, the Nifty Microcap 250 has zoomed 60.3 per cent!

More importantly, there is a pattern among the biggest gainers. These are all directly or indirectly linked to massive government spending that started a few year or two ago.

This includes:

1. Railway modernisation, which benefits stocks such as Jupiter Wagons (309 per cent), Texmaco Rail (261 per cent), and Titagarh Rail (207 per cent)

2. Government enterprises such as Mazagon Dock (233 per cent), Indian Railway Finance Corporation (190 per cent), and Rural Electrification Corporation (134 per cent)

3. Infrastructure companies benefiting from government plans such as Patel Engineering (270 per cent), a construction company with a focus on hydro power sector; Genus Power (227.6 per cent), which specialises in smart meters; and HBL Power (183 per cent), which is focused on batteries, defence and railway signalling

These stocks are running up for a reason -- strong and simultaneous government initiatives in multiple directions -- something we have never seen before.

In the last Budget, the government had allocated a stupendous Rs 10 trillion for infrastructure, of which, the railway ministry's allocation was Rs 2.40 trillion, a 75 per cent leap over that in FY23.

The Defence Production and Export Promotion Policy 2020 (DPEPP) has set a revenue target of Rs 1.75 trillion by FY25, implying a 15 per cent CAGR (compound annual growth rate) between 2019 and 2025.

Procurement from domestic industry would double to Rs 1.40 trillion by FY25.

The government shipyards (Garden Reach, Cochin and Mazagon) have their order books full for the next few years and are getting more and more enquiries.

The allocations made through the Budget are being spent liberally.

If pipes and tubes are doing extremely well, it is because of the Jal Jeevan Mission and, of course, civil construction, which is the basis for infrastructure building.

Companies doing government work are actually getting paid quickly, which is also a major departure from the past.

A small listed company, Zen Technologies, which has forecast a sharp rise in its revenues, told analysts that it got paid within 45 days of invoicing, thanks to the efforts of the defence ministry.

These are the reasons why companies from three segments -- defence, railways, urban infrastructure (including road, power, metro rail projects, water and sanitation) -- are a mad bull market.

But what explains the vertical rise in small- and micro-cap companies?

In the past two decades, four sectors grew massively due to demographic tailwinds: Software, pharmaceuticals, consumer goods, and financial services, including banking.

They also benefited from the lack of government intervention.

India's private sector has never previously benefited from well-managed, strong, and secular growth due to government schemes and spending.

In the past, growth due to policy initiatives was limited to roads, power, and mining.

In each of these sectors, shady business houses walked away with large, gold-plated projects with the help of collusive bureaucrats and bankers.

But they often failed to deliver due to inefficiency and corruption.

Today, massive spending on defence and metro rail projects, and the tremendous push for renewable energy and production-linked incentives (PLI) to boost manufacturing in 14 sectors have led to more broad-based and significantly larger opportunities for all.

Private companies operating in these areas are small to medium enterprises, because they never before had a growth opportunity that is a significant multiple of their current operations.

This has led to a sharp upsurge in the stock prices of this group of companies as the market is confidently discounting several years of growth.

For the past year or more, we are witnessing a new paradigm of growth, a development model that PM Narendra Modi had talked about, but did nothing to unleash in the first six-seven years of his leadership.

The question on everyone's mind is, will this be sustainable? The answer is not simple.

The current model remains hostage to multiple factors, in the absence of any effort to reduce the cost of overhead and logistics, and other frictional costs of doing business.

In order to create a sustained, self-reinforcing growth cycle and for spending to continue we need: One, tax revenues to remain buoyant.

Revenue from goods and services tax is continuing to rise on a year-on-year basis, but has plateaued this year.

Direct tax revenues are flat for the first four months, even as total government expenditure has jumped 23 per cent, mainly due to a 52 per cent increase in capital expenditure.

Two, the value of the rupee, which indicates the competitive strength of the economy, has remained weak and is getting weaker under the pressure of higher oil prices and lack of export competitiveness.

Three, government spending usually lacks oversight and only time will tell what the net impact of spending on railways and infrastructure is.

The benefit of defence expenditure is easier to visualise in terms of lower imports, higher exports, and expanded domestic manufacturing.

In effect, while the corporate sector has benefited from massive capital expenditure, leading to sky-rocketing stock prices, investors would do well to keep an eye on the macroeconomic picture and government finances, not just corporate profits, for signs of trouble.

After all, as smart investors would remind you, 'Everything is cyclical.'

In other words, when the cycle is rising, no one foresees or considers what could turn the cycle down.

But they inevitably do, especially those created by the government.

Debashis Basu is the editor of moneylife.in and a trustee of the Moneylife Foundation.

Feature Presentation: Aslam Hunani/Rediff.com