Overlooked By the Market, Undervalued Stocks Offer Long-Term Growth

The Indian equity market has been a fertile landscape for growth-oriented investments over the past few decades, as sectors like IT [information technology], pharmaceuticals, consumer and financial services have delivered stellar returns, driving investor enthusiasm for growth stocks. Yet, as valuations soar and growth stocks dominate, there lies a parallel opportunity in identifying undervalued gems.

In India, where economic cycles, regulatory shifts and macroeconomic variables add unique layers of opportunities, the task of uncovering undervalued stocks amidst the growth frenzy requires a strategic approach by discerning investors to navigate the evolving market dynamics.

Economic Growth Steadies

Structural tailwinds for the economy are driving markets as policies have pivoted to strengthening infrastructure, giving precedence to domestic manufacturing and boosting consumption by focusing on reforms to improve private investments. After a prolonged decline spanning over a decade, India's investment as a percentage of its GDP [gross domestic product] is on a steady upward trajectory. This trend suggests the potential for a growth cycle propelled by capex, where increasing investment-to-GDP ratios facilitate capital deepening and consequently boosting productivity growth.

India has embarked on a flurry of FTA [free trade agreement] signings, marking a significant departure from a nine-year hiatus in such agreements since 2021. Further, India is also benefitting from global supply chain diversification as all three components of the investment cycle—housing, corporate expenditure and government spending—are active. The revival of a multi-year investment cycle suggests a strong 6-7% GDP growth trajectory for the next three years.

With the turn of the economic cycle in India, earnings to GDP is showing a consistent increase which is expected to persist in the medium to long term. This typically leads to a broader range of sectors experiencing growth. These trends have spurred growth across industries, notable among them being sectors like consumer discretionary, wealth management, renewable energy and building materials. 

Subsequently, diving into growth companies that are undervalued requires investors to look into companies with a market capitalisation of Rs 1,000-Rs 5,000 crore, which are uniquely positioned to benefit from India's robust economic tailwinds. The government’s focus on infrastructure reforms, including initiatives like the Gati Shakti plan, FAME [Faster Adoption and Manufacturing of Hybrid and Electric Vehicles] incentive to boost EV [electric vehicle] penetration, PLI [production-linked incentive] schemes for accelerating value-added manufacturing and increased capital expenditure, have unlocked new opportunities for small and midcap companies, enabling them to scale operations and grow earnings.

Simultaneously, as India's per capita disposable income surpassed the $2,500 threshold, a key inflection point for consumption growth, sectors such as tourism, hospitality, retail and discretionary spending with significant demand expansion is being observed. India is also witnessing a shift from unorganised to organised sectors, driven by urbanisation, rising incomes and better accessibility.

Consumers are increasingly favouring premium and luxury brands, reflecting aspirational lifestyles and enhanced spending capacity. This trend is bolstered by the growing penetration of modern retail and ecommerce, bridging the gap between demand and supply. These drivers create a "sweet spot" for mid and small-cap companies to capitalise on infrastructure and consumption-led growth, delivering robust earnings trajectories in the medium to long term.

Identifying the Right Sector                    

Over the longer term, earnings will be the primary return driver so investors should invest in businesses that are fundamentally strong, have a competitive advantage, gain market share and grow above the industry average. The value creation playbook emphasises the interaction between growth, ROCE [return on capital employed] and the cost of capital to evaluate different return drivers, with earnings growth being the primary and multiple expansion being ad interim. The crucial part in selecting stocks that are to be “multibaggers” is identifying rapidly-growing quality businesses available at adequate discounts to intrinsic value.

The Indian market has a history of volatility, with macroeconomic factors like inflation, interest rates and currency fluctuations playing a significant role. Companies with strong balance sheets, low debt, sustainable earnings growth and consistent cash flows are better equipped to navigate these challenges. Corporate governance is a critical factor. Companies with transparent practices, shareholder-friendly management and minimal promoter-related controversies are more likely to deliver sustainable returns.

Leveraging emerging trends to identify sectors poised for exponential growth due to technological innovation or changing consumer behaviour operating in niche segments typically offer undervalued gems. Further, turnaround stocks, often emerging from financial stress or operational challenges, can be a source of undervalued opportunities.

Identifying undervalued stocks in a growth-dominated Indian market demands a blend of financial acumen, local knowledge and a contrarian mindset. By focusing on financial strength, governance and sector-specific trends, investors can uncover opportunities that others overlook. The domestic market is vast, with pockets of inefficiency offering significant rewards to those willing to dig deeper. As the balance between growth and value investing continues to evolve, the discipline of identifying undervalued stocks remains a cornerstone for building sustainable wealth.

(The authors are co-fund managers at Right Horizons. Views are personal.)