'More comfortable with mid caps, followed by large caps'

Summary: What’s driving the market now? A manager of two four-star-rated funds with nearly Rs 65,000 crore under his watch breaks it down. From stretched mid-cap valuations to smart portfolio shifts, get an inside view of what this seasoned investor is thinking.

With nearly Rs 65,000 crore in assets under his watch, Atul Bhole is no stranger to navigating market turns. Bringing over 18 years of experience in Indian equity markets, the fund manager at Kotak Mutual Fund helms the four-star-rated Kotak Aggressive Hybrid Fund and Kotak Midcap Fund.

At a time when growth indicators are softening and mid- and small-cap valuations appear stretched, Bhole’s investing playbook relies on fundamentals—backing quality management, tracking cash flows, and adjusting allocations in line with evolving sector trends.

In this interview, Bhole breaks down what sparked the sharp rebound in his mid-cap fund, offers a grounded view on valuations and shares why policy cues, festive tailwinds and disciplined stock-picking may fuel the next leg of market momentum. Below is the edited transcript of our interaction.

After a muted results season, Indian equities appear to be showing signs of fatigue. Do you think this is just a short-term breather, or could it be the start of a more sustained slowdown?

You're right. The slowdown is quite concerning. Last month, we saw GST (goods and services tax) collections grow by just 6.2 per cent, and most other high-frequency indicators, such as petrol and diesel sales or power consumption, are also slowing down. Obviously, this year we have seen the early arrival of the monsoon by almost one to one and a half months, and it has its implications. However, over the last six to eight months, policy actions have taken full effect. We have seen a significant comeback in government spending, both in revenue and capital expenditure.

At the same time, the Reserve Bank of India (RBI) has cumulatively cut rates by almost 100 to 125 basis points. Additionally, the 100-basis-point cut in the CRR (cash reserve ratio), which was a surprise, has also occurred. We are seeing inflation cooling down, which will have a positive effect on purchasing power. The monsoon is going well. Hopefully, all these factors, combined with the possibility of a cut in petrol and diesel prices due to oil behaving well despite geopolitical uncertainties, will also help.

And from next year, starting in January, the implementation of the Eighth Pay Commission can also provide a boost. Not to forget, we received a tax break of nearly Rs 1 lakh crore in this budget, which has already taken effect. While we are seeing a slowdown, which is quite concerning, with all these policy measures and some luck favouring us in terms of the monsoon and oil prices, I think we can see a good bounce back in the economy from the second half onwards. This will also reflect in corporate earnings. In my opinion, this should be a temporary slowdown. I will not call it structural at this point.

Mid- and small-cap stocks have rallied significantly over the past few months. Do you think we are at risk of froth in valuations?

Yes, valuations are obviously on the higher side; there is no denying that fact. If you compare mid- and small-cap valuations with those of large caps and against their long-term history, they are expensive by almost 25 to 30 per cent. That is certain.

However, if you examine the results of the last quarter of the previous financial year, mid-cap earnings growth has been significantly stronger than large-cap earnings growth. Large caps would have grown profits by around 7 to 8 per cent, while the mid-cap universe has seen earnings growth of 11 to 12 per cent. So, they are outperforming large caps in terms of profit growth.

Secondly, if you examine many high-growth areas supported by government reforms and initiatives, such as electronics manufacturing, defence companies, hospitals, hotels and consumer discretionary, they are high-growth segments within the Indian economy. Most of them are housed within the mid-cap universe. You will not find a large-cap hospital, a large-cap electronics manufacturing company or a large-cap hotel at present, although some may evolve into large caps over time. These sectors, being mid-cap-heavy, naturally receive higher valuations. If you look at PEG terms (P/E-to-growth), there is some reasonableness when you compare them with large caps. So yes, valuations are on the expensive side, but there are strong reasons for these expensive valuations.

Small caps, too, are expensive in certain pockets. Unfortunately, the delivery of earnings growth in small-cap stocks is not as robust. So, we have to be very careful while dealing with the small-cap universe. Generally, mid- and large-cap companies can handle uncertainties in a more prepared manner due to their stronger balance sheets and professional management. Small caps, however, tend to get tested more during uncertain times. Hence, I would be more comfortable with the mid-cap universe, followed by large caps. For small caps, one must be highly selective and cautious in stock selection.

From a macro lens, are there any indicators you're watching closely right now that could influence your market stance or portfolio strategy?

Given that we discussed the hopes for a recovery in the second half, I will be watching closely how the economy picks up, starting with the festive season. From August, we enter the festive period, which typically builds up to October and November, marked by festivals such as Diwali and Dussehra. We conduct regular channel checks to track pickup in auto sales, air conditioner sales and durable goods sales during this period.

I think these kinds of macro indicators, or I would say channel checks, are essential for us. Hopefully, from the festive season onward, we should see a pickup in sales. This will be a critical test for the economy and markets going forward.

In terms of strategy or framework, it remains the same, focusing on quality management and business growth. Fortunately, if you look at the Indian economy, it is multi-legged. We have a very robust banking and NBFC (non-banking financial company) sector, strong infrastructure and capex names, excellent exporters in IT, pharma and chemicals, and a wide range of well-positioned consumption-related stocks to invest in.

At any point in time, at least one or two of these sectors tend to fire. Therefore, if we continue to look for inflection points within sectors and stocks, I believe we can continue to capture returns. Rather than compromising on the framework or philosophy, I prefer to rotate money between sectors and stocks. I believe we have ample opportunities to keep doing that.

Your investment philosophy places a lot of emphasis on management quality. Has that approach evolved in any way in response to the current market environment?

I would say that only minimal tweaks have been made, but looking at the quality of the promoter or management is a cornerstone that we cannot compromise on. Over the last 10-20 years, we have seen numerous examples of companies built by strong promoters and management teams that eventually became average businesses. And I think that is completely a result of management quality. The external environment or situations are broadly similar for all companies within a sector or the economy. What makes the difference is the strategy and execution by the management. So, I consider management quality as a non-negotiable parameter when selecting stocks.

When it comes to picking stocks, you spoke about your investment strategy. But beyond the usual filters like valuation and growth, what moves the needle for you?

To make money, growth is required, and the starting valuation, which we pay while buying the stock, is also crucial in determining returns. But apart from that, one big factor, as I mentioned, is management quality, which is non-negotiable.

The second is the business itself. Along with these company-specific aspects, such as business strength, management, valuation and growth, the sectoral tailwinds and headwinds also matter when it comes to generating returns.

So, I would say it's a combination of factors, but in terms of priority, it's the business and management first, followed by growth and then valuation, essentially in that order.

Essentially, it's not a single-view approach, focusing solely on management or the business value chain. Are there any specific filters you examine within these three segments?

Yes, these are slightly qualitative aspects, but we do have some quantitative filters. We look for companies with a minimum growth rate of 10-12 per cent. We also analyse the type of capital allocation decisions management has made in the past, including how many times they have diluted equity, their approach to debt and capital efficiency.

Cash flow is another critical factor, specifically cash flow from operations, because it provides the capital to build future capacities. These are some of the parameters we always evaluate.

Lastly, market share is crucial. Typically, we prefer companies that are increasing their market share, as that is where long-term wealth creation is most likely to occur.

The Kotak Midcap Fund has seen a solid turnaround, moving from the third quartile (three-year) to the first quartile (one-year) over the past year. What drove that shift? Was it more about sectoral calls or individual stock selection?

At the portfolio level, I think what worked for us was that, despite everyone calling the market expensive, we did not take any significant cash calls. Earlier, the portfolio had some cash, which we deployed wisely. Wherever we deployed, those calls fortunately played out very well.

Secondly, our sectoral and stock rotation worked in a big way. If you recall, around mid-last year, specifically June–July 2024, following the election results, there was a lot of hype and exuberance in sectors such as Power, Defence and Manufacturing. At that time, the fund had significant exposure, around 30-32 per cent to these sectors. During that rally, we trimmed positions quite aggressively, reducing exposure to around 16-17 per cent. We redeployed that money into sectors that were neglected at the time, particularly IT mid caps, some chemical companies and hospitals.

Those calls worked perfectly. Following our profit booking, most Capital Goods and Defence stocks corrected by 25-30 per cent, while IT mid caps and Hospital names performed very well. So, we managed to avoid the correction in capex names and captured the rally in IT. Apart from that, there were three to four individual stock-specific calls that also played out well for us.

Looking to start a Rs 5,000 SIP in a strong mid-cap fund?

At Value Research Fund Advisor, our Analyst’s Choice includes a carefully curated list of mid- and small-cap funds to help you diversify and grow your portfolio.

Build long-term wealth with clarity and confidence.

Join Fund Advisor today