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Equity markets have witnessed volatility in recent times. This, after a strong rally since early 2014, is unnerving investors. Weak results in the last quarter, approaching rate hike by the US Federal Reserve, and higher price-earning (P-E) valuations are deterring fresh allocation from existing as well as potential investors.

The weak last quarter results were a function of lower capacity utilization, increased working capital cycle, lower commodity prices (which reflected in inventory losses), lack of investment and delayed execution of existing projects over the past few quarters.

However, fundamentally, Indian economy is gaining from lower crude and commodity prices. Inflation is moderating. Wholesale inflation is in the negative and the consumer inflation is below the target level set by the Reserve Bank of India (RBI). Fiscal deficit is under check and the current account is expected to generate a surplus. Investment cycle is being started by incremental spending in the roads and railways sector by the government. RBI is cutting policy interest rates. Gross domestic product (GDP) growth is bottoming out and will start inching up over the next few quarters. Capacity utilization across sectors may start going up as fresh capacity is not being added. Lower interest rates and commodity prices may reflect in better margins over the coming quarters. Thus, the prospects of better earnings growth will keep the market supported.

In the larger picture, India looks better vis-a-vis the investable alternatives in the BRICS group (Brazil, Russia, India, China and South Africa) and other comparable emerging markets. Russia, due to drop in oil prices, and Brazil, due to lower commodity prices, stand on weak wickets. China is trying to reckon with credit-led investment and is realizing the limitations of its exports and investment-led growth model.

The Indian market, despite its attractiveness, is only trading at a limited premium to its weakened peers. Having said that, rising foreign investors’ interest, even in the unlisted Indian e-commerce and technology companies’ space, indicates that flows in the listed market is also bound to be robust. While flows from foreign institutional investors (FIIs) in 2014 came more from exchange-traded funds and global emerging market funds, this year’s FII participation is likely to be more broad based.

Indian retail investment behaviour is also witnessing a tectonic shift, from “hard-asset" investments to financial investments. Word of mouth publicity by many satisfied retail investors, who have been regular and have invested for the long term in Indian equity, is resulting in robust inflows in the equity mutual funds.

The insurance sector, in all likelihood, will become a positive contributor to flows in the equity market in the coming quarters. Consequently, the demand offtake from both local as well as global investors will push prices higher for quality stocks.

Supply of paper will increase in coming quarters as divestment, growth capital and deleveraging requirement of Indian companies pushes more issuances. This may put a ceiling on the upside potential of the market in the short run, but the quality of issuance is very good from the business model point of view. Pricing, being market driven, will find its own equilibrium after a few trials and errors.

In the past 18 months, the bulk of returns in the equity market came from valuation expansion. P-E ratio for the Sensex expanded from about 13 times to 16.5 times. Returns in the next 24 months are likely to come from earnings growth. It will be unfair to expect higher expansion in valuations from current fair value levels.

The valuation gap between the large-cap and mid-cap segments favours near-term investments in large caps. In fact, the back-ended earnings growth can put some mid-cap stocks on a correction mode. Some of the quality stocks across FMCG, auto ancillary and some other sectors are trading at high valuations. They may witness some time correction for earnings to catch up.

The present valuation of quality stocks is sustained by lack of fresh issuance and continuous buying support from investors, who are pouring money into their comfort zone. It is likely that moderately valued stocks will outperform the ones with cheap or expensive valuations. It is likely that stocks of companies with less debt will outperform those with heavy debt.

The divergence between sectors will narrow but stock performance within a sector may widen. Thus, it will be important to blend top-down macro call with bottom-up valuation-driven analysis to create outperformance.

The returns from the equity market over the next 24 months will moderate substantially compared with the performance of the past 18 months. However, equities as an asset class are likely to still outperform other alternatives. Investors should take full advantage of every correction in the market to increase their allocation to equity.

Nilesh Shah is chief executive officer, Kotak Mahindra Asset Management Co. Ltd.

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