A sign that reads and quot;Caution and quot; is displayed on a recently washed sidewalk in front of a residential building in downtown Los Angeles, California, U.S. (Photographer: Kevork Djansezian/Bloomberg)

Beware of Small Caps and Regulation, Indian Fund Manager Says

(Bloomberg) -- With national elections set to potentially shake up Indian markets this year, the $1.5 billion Matthews India Fund has a bit of advice: don’t buy small caps or stocks that are easily influenced by the government.

“Large-capitalization stocks currently represent the most attractive part of the Indian stock market as valuations are broadly in line with historical averages and expectations for future growth are achievable,” said Peeyush Mittal, a co-manager of the fund based in San Francisco.

Beware of Small Caps and Regulation, Indian Fund Manager Says

The Matthews India Fund has reduced its holdings of mid-sized and small stocks to about 62.6 percent of its total portfolio as of Dec. 31 from 73.5 percent at the end of 2016, data from its annual filings show. The fund, which has returned an average of 15 percent annually over the past five years versus about 12 percent for the S&P BSE 100 Index, also has moved away from industries that are highly regulated or at risk of government intervention. Government stability is key, Mittal said.

“A government formed with the support of too many small political parties lends itself to instability and dampens the confidence of businesses at large to make the future investments necessary for growth and innovation,” the fund manager wrote in an email.

Read QuickTakes on Indian elections

Indian investors are getting jittery about the prospects for the reelection of Prime Minister Narendra Modi. While Modi’s policies including a cash ban in 2016, helped fuel equity investment, confidence in the economy has dwindled amid his failure to create jobs and address distressed farms.

The S&P BSE Sensex Index has managed a gain of only 1.4 percent so far in 2019, slightly extending a 38 percent, three-year rally. Smaller stocks have already started to decline, with the S&P BSE Small Cap Index shedding 24 percent in 2018. This could spell trouble for the market overall, Mittal said.

“As real estate and gold have underperformed, there has been a tremendous shift in the type of savings to financial assets,” the fund manager said. “This has led to consistent inflows in equity mutual funds over the past two to three years. If small- and mid-cap stocks continue to underperform, however, there is a risk that equity inflows turn to outflows, which might lead to a sharp correction in stock prices.”

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