If Q2 earnings are weak, markets will correct: Niket Shah

In a market that's breaking records almost weekly, few voices carry as much weight as Niket Shah's. A seasoned fund manager with nearly 15 years of experience, Shah is the chief investment officer (CIO) at Motilal Oswal Mutual Fund, where he oversees nine equity schemes worth around Rs 43,800 crore. His funds, particularly the Motilal Oswal Flexi Cap Fund, have staged an impressive comeback since 2023. The mid-cap and large & midcap funds have also emerged as stellar performers.

In this interview, Shah discusses the factors behind his funds' turnaround and outlines potential scenarios for market corrections. He also shares insights on how substantial value is still to be found in the current frothy market.

Below is the edited transcript.

The Sensex has been hitting new highs almost weekly. Do you believe this rally can be sustained? What key factors do you think are driving the market, and what could keep it going?

We consider two factors in the markets: fundamentals and flows or liquidity. In the last three years, markets have run up fast, but I think no one has taken the time to focus on earnings. Earnings growth for Nifty companies over the last four years has been about 22 per cent. The compound annual growth rate (CAGR) for mid-caps has been close to 36 per cent, and for small-cap companies, it's nearly 48 per cent. So when you have these kinds of growth rates, which we have never seen for mid-cap and small-cap companies since the index was formed, it's bound to happen that we will see a material amount of rerating in those stocks.

If you look at the returns of those indexes, it's actually mirroring earnings plus or minus 2 per cent. Similarly, the largest change in the liquidity side has been attributed to the increased participation of retail investors. The number of demat accounts is increasing monthly, and mutual fund flows are quite strong. Domestic institutional investors and retail investors own 85 per cent of the market, while foreign institutional investors own the remaining 15 per cent. So when 85 per cent of the market keeps buying, and 15 per cent keeps selling, there is no impact on the overall market.

These two factors have contributed to the market's continued buoyancy. In the past, investors initially invested in large-cap stocks before transitioning to mid- and small-cap stocks. But now we are seeing so much passion and love for unlisted equities. So, the risk-taking ability of retail/HNI/institutional investors on the domestic side has only gone up.

Do you think this rally can continue?

In the last 16 quarters, the last quarter (June 2024-25) was the slowest. We've seen about 4-5 per cent earnings for large-cap companies and 7-8 per cent for mid-cap companies. Now, we can attribute this to the election season, which is why I believe the second quarter earnings will serve as a significant litmus test. If we continue to see weak earnings in the second quarter, I believe the market will start experiencing some corrections. We have already seen some sell-offs in many sectors where valuations were expensive and no earnings support. Therefore, we anticipate a period of consolidation, necessitating significant churn within sectors and themes. Otherwise, it's extremely difficult to outperform across durations.

Moreover, I think everyone has been saying valuations are expensive, so the market should correct. Markets don't correct because valuations are expensive. They correct when there's an earnings downgrade cycle, or anything goes wrong globally. Prices have been costly for the last 18 months. It didn't get expensive yesterday; from that standpoint, the market continues to rally. I believe the market won't materially decline until strong earnings growth and a reasonable amount of liquidity exist.

That said, the macro data from the US is slightly concerning, and at the same time, India is experiencing a slowdown in earnings, so we believe the market will consolidate. We don't expect a big rally in equity markets, but we don't expect a big correction either. We won't see sharp corrections of 25-30 per cent, but yes, one can't rule out 8-10 per cent of the market corrections. Even if you look at the 2004-2007 rally, we had seven corrections, of which two were close to 30 per cent each. Yet, before this one happened, we all knew that it was the biggest bull market. Correction doesn't mean the bull market is over. I believe we are currently in a structural, 10-year bull cycle in India. I don't believe we should declare the end of the bull market and predict a market crash.

With valuations at record highs, is it getting tougher to find good investment opportunities? How do you go about identifying value in this kind of market?

I believe that there is always value and mispricing in the market. We believe you should focus on sectors where valuations are significantly lower while also considering earnings.

We believe that IT growth should resume once the US elections are over. Assuming a marginal increase in growth for certain IT companies, the current valuations would appear more affordable. This is why we took an overweight position in the IT sector a few quarters ago, which benefits us now. We also took overweight positions in the pharma sector, and that's benefiting us in some sections. We have moved out of real estate, capital goods, and some large beta stocks, such as banking. We have close to zero banking exposure and have invested in non-banking financial companies (NBFCs), where our weights are very high.

Therefore, I would argue that our portfolios are extremely well-positioned. Currently, our portfolios are heavily weighted towards IT and telecom, consumer discretionary, and some manufacturing sectors, where we anticipate significant earnings growth in the future. We don't want to take a disproportionate risk at this point in time and move up the quality curve. In fact, in the last two to three months, we have invested in small-cap stocks, which have gone up by 60-70 per cent since we bought them. While valuation is expensive and there is froth in certain segments, we should not paint that brush on the entire market. There is still a lot of value in the market, a lot of stocks that we continue to believe can give you a two to three-times return in the next two to three years, and they're still available right in front of our eyes.

Motilal Oswal Flexi Cap had a tough stretch from 2018 to 2022 but bounced back strongly in 2023 and 2024. The Midcap and Large & Midcap funds have also been stellar performers over the past few years. What factors supported this turnaround? Did any specific sector calls contribute to this performance?

It all started in 2020. Initially, we went overweight on IT post-Covid because we had no idea what sectors would do well. People across the globe were holding meetings through Zoom, and it appeared that without tech, there was no way out, as there was no clarity on when the world would open up. We thought this sector might do well, so we made proportionate returns by betting on the IT sector.

In December 2021, we revisited the thesis and saw there were no costs as everyone was sitting at home, so there were no visa and travel costs, while the revenues were solid and margins were great. But we thought things would change once the economy opens up, as people would start travelling and going to offices, and topline growth would slow down, and hence, the value and earnings downgrade cycle would happen. In 2021, the valuations of the IT sector had started to turn expensive. So, we went to zero weight in IT and were significantly overweight in the banking and capital goods sector. As the economy opened up, banks did very well. Fast forward to a year later, we exited banks and went overweight on NBFCs, consumer discretionary and real estate as we thought the interest rate cycle had peaked.

At the beginning of the current year, we exited real estate and went overweight on telecom. Now, we have exited capital goods and gone back to IT and pharma. So that's how we've navigated this whole cycle. The right selection of the sector and theme, what stocks to buy within that sector and theme, book profit in that stock, and then move to the next sector or theme, and what stocks to buy within the next theme. If you keep doing this virtuous cycle repeatedly, then I think you will end up beating the index over time.

Your ELSS fund has one of the most concentrated portfolios in the category, with nearly half of the fund allocated to mid and small caps. Given that these segments have already rallied by over 30 per cent, are you considering a shift in your allocation strategy moving forward?

We have been reducing allocations to small caps and mid caps in the ELSS fund while slightly increasing allocations to large caps. However, this does not mean the entire portfolio is biassed towards large-cap stocks. We fundamentally believe that the businesses we have on the mid-cap side, in the range of Rs 50,000-70,000 crore market cap, have a very strong balance sheet. So a slight correction would not affect them.

We believe that some of these mid-cap or small-cap companies are fundamentally strong, their growth rates are very healthy, and they will continue to do very well across market cycles. So, we don't want to move towards large caps just because we believe valuations are expensive. I don't think that's going to happen. We will definitely reduce the portfolio's risk by moving more towards large caps, but we will continue to own quality mid caps for the long term.

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