Revathi Asset Management

The long and short of it

Let’s take a look at where bear markets come from. Since 2004 till mid-2023, the Midcap 50 index has consistently underperformed the Nifty 50. In terms of risk-adjusted performance and institutional metrics, it would not be accepted into large portfolios. This all changed in March 2023 after the collapse and bailout of Silicon Valley Bank and Credit Suisse.

Suddenly, after June 2023, the mid-cap space exploded higher, significantly outperforming the large caps and invalidating a 20-year history and analysis. Let us compare the risk-return stats from 01-01-2004 to two ending dates, 01-01-2025 and 01-01-2023.

Analysing the stats till 01-01-2025 with an institutional lens, the MIDCAP 50 almost looks investible. The max drawdown is higher, but so is the total return. The monthly Sharpe ratios are similar and the sortino ratio, which measures return over downside volatility, is marginally higher for the Midcaps. The Calmar ratio, measuring returns over max drawdown, is understandably lower for mid-caps, but in the end, a case could be made that, for those looking for higher returns, the Midcap 50 offers investors commensurately higher return for the higher risk they are taking. All good so far.

Now let’s analyse the stats till 01-01-2023 in the same way. CAGR is lower, max drawdown is higher. Not good. As a result, all 3 risk-adjusted metrics are worse for the midcaps than for the Nifty. You were taking higher risk (i.e. higher max drawdown), and getting lower returns (i.e. lower CAGR) and higher volatility (i.e. lower sortino/sharpe) for 20 years. Only in the last 2 years has this changed. So, the next time your financial advisor says “Higher risk = higher reward,” you’ll know he’s just selling you something.

Bonus round: Let’s analyse the stats from 01-01-2023 to 01-01-2025 to see the difference the last 2 years have made. The results are stunning: the max drawdown is similar, the CAGR is a full 20% higher, and the risk-adjusted metrics are more than twice as high across the board for midcaps than for the nifty. A seriously great time for those invested in midcaps. However, the reason we isolate these 2 years is to show that if you’re stock market history is limited to this period, you will have a very idiosyncratic view of the markets and what happens most of the time.

The trend is your friend

The outperformance in the midcap space we just discussed has coincided with a massive expansion in the number of active demat accounts in India. At the time of writing, numbers are not out for Jan 25, but we could expect around 2.2 million active accounts. The majority of these additions have come in 2023 and 2024, adding an estimated total of about 1 million demat accounts.

The same has happened in the SIP space and here we may be getting closer to the real culprit fuelling this blind rally in midcaps. Annual SIP inflow was about $1 billion ~= INR 8500 Cr in FY20 and has likely gone well above the $ 2.5Bmark in FY25. Talk to any retail participant in the market today and you’ll find that the blind faith in the implied bid in the market due to domestic SIPs dwarfs the religious sentiments of most.

Fanning the flames is the rise of “finfluencers,” who are taking to the digital streets every day and pushing the case for mutual funds, higher equity risk, and systematic investment plans (SIPs) onto retail investors every single day. My LinkedIn on any given day is inundated with financial experts generating “content” that does nothing other than advertise their services under the garb of “financial knowledge.” Attached below is an actual post from my feed, anonymised for privacy. While the post talks about the Nifty, the logic is obvious and the implication is clear: higher volatility = higher return. But remember, that’s not what we saw from 2004-2023.

Furthermore, the demographics of the retail investing public are also indicative of what’s happening and why. From FY19to FY23, the share of under 30 year olds in the market increased from 29% to 48%. A basic fact about financial reality is that if the average person starts their career at 22, the vast majority will simply not be saving enough money to be “investing” in the stock markets before the age of 30. From the ages of 22-30, the average individual barely saves money after taxes, rent, food, transport, and basic necessities to be investing in the equity markets.

Until the bend in the end

The trouble with the stock market is that you can throw as much logic, stats, and math at it until you’re blue in the face. It probably won’t listen to you. Talk about the long term to a new investor in the market and you’ll have to hear Keynes’ maxim, “In the long run, we are all dead.” To make matters worse, he’ll say it as if he has imparted some unfathomably profound knowledge that the world has never seen. This, however, is the financial equivalent of “Whatever.”

The problem with the market is that its irrationality compounds until it doesn’t, in which case it just as rapidly unwinds and then compounds in the opposite direction. There’s no predicting the madness of crowds, there’s no timing it, and there’s no modelling it because it’s driven by human emotions, public sentiment, and overall market positioning.

For those, however, who are factual and objective about reality, the signs are clear enough. Below is a newspaper cutout that shows the holdings in a certain stock across 5 different funds. The stock is a midcap, with a market cap of around 75,000 Cr on Dec 2024. In the best case, this is sheer hubris and financial mismanagement; in the worst case, it is market manipulation. On Dec 31 2024, the stock had a P/E ratio of 128.

The stock is KALYANKJIL, Kalyan Jewellers India Ltd. In their January 2025 concall, an investor raised a question asking whether the rumours were true that the promoters had bribed mutual fund managers to include the stock in their portfolios. The stock was down over 35% in the next 10 trading days.

We bring this up not to infer market manipulation. We discuss it to suggest that such an event was inevitable. The stock had a gross margin of 9.5%, a free cash flow margin of 1.9%, and an ROE of about 15% on Dec 31, 2024. While the top line revenue was growing at around 30% YoY, EBITDA had flatlined to around 5% YoY growth in Q2 2024. Anyone who has studied finance or worked in the industry, knows intuitively that such metrics don’t support a 128 P/E ratio. They likely would not have invested their own money, let alone institutional money.

Yet KALYANKJIL was one of the best-performing stocks in 2023 and 2024, returning over 183% and 111% respectively. If your friend had it in his portfolio and you didn’t, you would have been implicitly ridiculed. He would have taken every single opportunity to remind you of his “favourite stock that’s up over 100% this year” for a full 2 years.

The problem with such stocks and times in the market is that they teach you all of the wrong lessons. If you had bought this stock at any point in time, you would have been up on your position on Dec 31, 2024. You would have been on top of the world. But you would have committed the only cardinal sin of the markets: you would have thought you knew something about them.

It’s the valuations stupid

In finance, the first thing they teach you is discounted cash flows (DCFs). You start with pricing a bond. Let’s say the bond has a face value of 100. It yields 10% interest a year, for 10 years and on the 10th year it returns the principle of 100. Let’s say the risk-free interest rate (e.g. 10-year government bond yield) is also 10%. On a discounted cash flow basis, the current price of the bond is also exactly 100.

That was the easiest example possible because all numbers had been rounded to serve that very purpose. Now let’s try a 100 face value bond yielding 10% annually with the risk-free rate at 7%. We now get a price of 121.07 for this new bond. Intuitively, this makes sense. We are getting higher cashflows than the risk-free interest rate. Therefore, the price of the bond should be more than the face value of the bond.

The next logical step in corporate finance is to treat a stock’s dividend payments like a bond’s cashflows. Assume for simplicity’s sake that a company’s share pays out a dividend of Rs 10 annually, with the government risk-free rate at 7%. So, for 10 years, let’s model out the dividend cashflows, similar to above.

However, for equities, there’s no principle value to be returned at “maturity” because equity never matures. Instead, we use the Gordon growth rate model to come up with the “terminal value” of a stock; we use the latest dividend and estimate a long-term cost of equity capital and dividend growth rate to come up with a share price, which we then discount back to the current period. For our terminal value, we estimate a 12% cost of capital (r) and a 10% dividend growth (g) making r-g=0.02 or 2%. Terminal value equals the last dividend divided by r – g.

While in reality a stock’s cash flows and terminal value will never be so predictable, the point here is that we have a logical, mathematical, and financial framework with which to rationally value a company’s stock.

On Dec 31, 2024, KALYANKIL had a TTM EPS of 6.08 per share. Its last dividend payment was Rs 1.2, equating to a dividend payout ratio of about 20%. Let’s make the same calculation as above. Remember that while the top-line revenue was growing at around 30% YoY, EBITDA had flatlined to around 5% YoY growth in Q2 2024.

Let’s take a very generous 30% EBITDA growth per year and let’s assume that it translates entirely into EPS growth, so we’re continuing to remove any effects of debt or depreciation. We keep the same terminal value assumptions of a 12% cost of capital and a 10% discount growth. Given our assumptions, we get a fair share price of only 233.43. For comparison, the stock price was 766.25 on Dec 31, 2024.

We have downplayed the generosity of our assumptions:

1. We don’t consider interest at all (let’s say a jeweller has no depreciation), even though the company has a long-term debt to equity of 0.27.
2. We assume annualised 30% bottom-line EPS growth for the first 10 years starting 2025
3. After that, we assume 10% growth in perpetuity for the dividends paid out by the company
4. We assume that margins will not decrease despite such aggressive compounded growth
5. We assume future capital will not have to be raised to expand so aggressively (debt leads to interest payments and more equity shares equals lower EPS for the same earnings)
6. We assume a very cheap terminal cost of capital at 12%. Note that the higher the terminal cost of capital, the lower the terminal value of the stock

A lot of market commentary will now revolve around throwing blame or finding reasons why the stock crashed so hard. But if you look at the cold, hard reality of the situation, this stock was trading at almost 3x the price it was “supposed” to. And that’s after we’re being extremely generous. If we priced in a safety margin, the fair value would be much, much lower.

In the end, this stock didn’t deserve to be trading where it was. Even after the 35% correction, it is nowhere close to being fairly valued. The crash was merely the perfect storm of inadequate fundamentals, market mispositioning, and false billing to clients that equity markets are safe and that risk is the source of returns.

Notice that we have not discussed risk at all when valuing a company. That’s because risk only detracts from a stock price. What matters in the end is cash flow (otherwise why are paying money for a financial asset and calling it an investment?) and the fair pricing and estimation of future cashflows. If cashflows are volatile, then the markets pay a discount for them, not a premium. Unfortunately, in finance, uncertainty is a bad thing, not a good thing. In the end, when market prices get so disjunct from reality, such violent corrections are inevitable and necessary.

The perfect storm

We are of the utmost belief that the recent mania in midcaps will not continue. We have seen this clearly with some back-of-the-envelope calculations with a specific stock market darling (or is it culprit?). Remember that the Midcap 50 has returned 20% more in CAGR than the Nifty 50 for 2023 and 2024 but underperformed from 2004 to 2023. We have just seen how one specific midcap was 3x overvalued at the end of 2024, despite using very generous assumptions.

Again, we don’t highlight this issue to throw shade at a particular stock or any funds that may have given it an unnecessarily high concentration in its portfolios. We are highlighting the facts that:

1. The recent outperformance in midcaps has been unprecedented.
2. There has been a huge influx of new, young investors who are not well-capitalised or financially experienced.
3. There has been a nauseating rise in publicised, financial misinformation.
4. There is a very clear case of unparalleled overvaluation in certain parts of the markets.
5. One should not be surprised if this outperformance reverses and eventually destroys investors’ capital.