Fund managers find comfort in largecaps as Sensex tops 70K

Following the sharp run in markets, valuations across the board have become elevated.

The National Stock Exchange Nifty50 Index now trades at a 12-month trailing price-to-earnings (P/E) multiple of 24.3 times, 18 per cent higher than this year’s low of 20.5 times.

The valuation expansion in the broader markets has been sharper.

The Nifty Midcap 100 currently quotes at 33x 12-month trailing P/E, up 46 per cent from March levels, while the Nifty Smallcap 100 valuation has soared by 80 per cent to 30.1x.

As things stand today, fund managers believe the largecap space offers better value vis-à-vis the red-hot midcaps and smallcaps.

“If one looks at the broader market, the midcaps and smallcaps have outperformed the largecap indices by a meaningful margin in the recent past — the past six to 12 months or even two to three years.

"At present, largecaps appear to be still reasonably valued, more so compared to midcaps and smallcaps,” said Rajat Chandak, senior fund manager, ICICI Prudential Mutual Fund (MF).

What gives fund managers comfort is that the current Nifty and Sensex valuations are in line with their five-year averages and haven’t overshot despite the sharp 22 per cent upmove from March lows.

“The recent rally has pushed up valuations but they are not yet in the expensive zone.

"They are largely in line with the long-term average,” said Harsha Upadhyaya, chief inves­tment officer (equity) at Kotak Mahindra MF.

The widening of the valuation differential between largecaps, and midcaps and smallcaps can be attributed to investor flows.

Foreign portfolio investor (FPI) flows have a relatively greater bearing on the stock price movement in largecaps.

As FPIs have ebbed and flowed over the past year, largecap performance has remained muted, say experts.

On the other hand, a large part of strong domestic investor flows has found its way into smallcap and midcap stocks, either through MFs or through direct investing.

Industry players say as domestic funds are chasing the strong momentum, the broader markets are getting more and more overheated.

Taking cues from balanced funds

The asset allocation strategy of balanced advantage funds (BAF), MF schemes that invest in both debt and equities depending on market conditions, often gives a cue on whether fund managers see the equity markets as expensive.

There are no major red flags there yet as most allocation remains in the mid-range.

ICICI Prudential BAF, the second largest in the category, had trimmed the equity allocation to 40.2 per cent at the end of November from 43.6 per cent a month ago.

The fund, which manages close to Rs 50,000 crore, allocates between 30 per cent and 80 per cent to equity depending on market conditions.

In the case of the other larger fund in the category, of Kotak MF, the equity allocation stood at 50.2 per cent at the end of November, slightly higher than the October-end exposure.

“The equity allocation reflects our view on equities.

"At the end of November, the fund was 50.2 per cent equity, which falls in the middle of our 20-80 per cent range.

"It has gone up compared to October owing to changes in other factors like momentum and market trend,” said Upadhyaya.

The Edelweiss BAF, which follows a pro-cyclical asset allocation model as opposed to the more common countercyclical approach, has raised the equity allocation significantly since November.

“In our model, valuation is not the primary factor.

"Our equity allocation generally goes up during the bullish phase of the market and comes down when the market weakens,” said the fund’s manager Bharat Lahoti.

The fund’s equity allocation, which was closer to 47 per cent at the end of October, had risen closer to 70 per cent by the end of November.

According to Lahoti, the allocation continues to inch upwards in December.

To be sure, not all funds are equally dynamic due to tax implications.

According to tax rules, MF schemes have to maintain a minimum 65 per cent equity allocation to qualify for equity taxation.

While some BAFs use hedging to maintain the desired equity allocation on a net basis, others manage the fund with a largely fixed

65-70 per cent equity allocation.