(Bloomberg) -- Investors are starting to weigh the merits of rotating into small- and mid-sized Indian stocks after a few large companies drove a record-breaking rally in the main equity index.
“Leadership in India’s rally has been very narrow,” Tim Moe, chief Asia Pacific equity strategist for Goldman Sachs Group Inc (NYSE:GS)., said last week in Mumbai. “Valuations are at the high end of the range, both in historical terms and relative valuation compared with the region as a whole.”
The S&P BSE Sensex has risen about 12% from a low in September, with three members -- Reliance Industries Ltd., ICICI Bank Ltd. and HDFC Bank Ltd. -- accounting for 61% of all the gains. The broader market has lagged behind, leaving the valuation gap between smaller firms and the gauge at close to its widest in a decade.
“Many of India’s large caps are overvalued,” said Sunil Singhania, founder of Mumbai-based Abakkus Asset Manager LLP. “Most of them are unlikely to grow at the rate expected of them.” Abakkus has about 75% of its $300 million in assets invested in small and medium-sized stocks. The firm earlier this year said some quality stocks are likely in a “bubble zone.”
Investors have taken shelter in some of the South Asian nation’s biggest companies amid a credit crunch and the slowest economic growth in six years. That’s added to an extended underperformance by small stocks that goes back to 2017.
READ: India’s Economy Is Sputtering. But Its Stock Market Powers Ahead
Still, Chandresh Nigam, who oversees $14 billion of assets at Axis Asset Management Co. isn’t convinced there’s value in small caps. It is worth paying more for shares of high-quality businesses, he said in an interview last month.
Quality can be expensive, with the Sensex trading at 19 times 12-month blended forward earnings. That’s close to a level that’s proved the ceiling for gains in the past few years.
Yet, the bet has paid off for Axis, with the money manager’s largest equity fund beating 96% of peers in the last five years.
For market breadth to widen, economic outlook needs to improve. Analysts at Goldman Sachs (NYSE:GS) predict the growth is set to return. High valuation has partly priced in the expected recovery, with the MSCI India Index trading at 1.2 standard deviations above its 10-year mean, they wrote in a note.
There are signs investors are warming up to mid-cap stocks. The Nifty Midcap 100 edged out the benchmark index since the start of October, rising 6.3% versus a 4.8% gain for the NSE Nifty 50 Index. The Sensex was little changed at 9:37 a.m. Monday after losing 0.9% last week, its first weekly loss in more than a month.
“Early signs point to a change in market undercurrent,” Navneet Munot, chief investment officer at SBI Mutual Fund said in a note on Tuesday. “‘Value stocks’ have significantly outperformed ‘quality’ over the past two months.”
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(Updates with Monday’s trading in penultimate paragraph)
