However, since hitting all-time highs in late Sep’24, the trend has reversed with small-cap equities slipping into a bear market, commonly defined as a 20% drop from peak to trough, with the Nifty Smallcap 100 index down 25%. The Nifty Midcap 100 Index and the Nifty 50 Index have seen a 21% and 16% drop respectively from their Sep ’24 all-time highs.
Further, the breadth of the small cap index is much weaker, with 87% of small-cap stocks down over 25% and nearly 25% of stocks down over 50%, a ratio much higher compared to large-cap and mid-cap equities.
Given the significant pullback at the index and much sharper corrections in individual stocks, investors would be wondering if it is the right time to look at small-cap equities. We find conditions are turning positive for improved performance of small-cap equities.
- Macro fundamentals are supportive for small-cap equities outperformance: Headline GDP growth in Q3 FY2025 came in at 6.2%, 60bps higher to the cyclical low of ~5.6% in the previous quarter, indicating a potential rebound from the growth slowdown witnessed in the last few quarters. We have seen a broad-based pick-up in government Capex since Dec’24 and other high frequency indicators like GST collections, PMI, auto sales.
Further, fiscal and monetary conditions have turned supportive since the start of 2025, ahead of market expectations. The tax stimulus of 0.3% of GDP in the Union budget is likely to boost aggregate demand and support a revival in consumption. The government sticking to the path of fiscal consolidation provided the RBI with the room to commence its rate easing cycle, with the first rate cut in 5 years. Further, numerous liquidity measures in January and February, indicate the onset of easing financial conditions. Historically, supportive fiscal and monetary policy has resulted in small-cap equities outperformance relative to both, mid-cap and large-cap equities.
- Small-cap index is more diversified across sectors and industries: The index has expanded post COVID with new listings/IPOs in many new age sectors. This has resulted in improved liquidity with the free float for the index now close to 50%. Further, we see a broader representation of sectors like chemicals, pharma, auto components, capital goods along with exposure to structural themes like digitalization, growing affluent consumer and manufacturing.
- Greater valuation comfort compared to mid-cap equities: Small-cap equities valuations are more reasonable compared to mid-cap equities. The valuation premium (12-month forward P/E) of mid-cap equities to large-cap equities is at 50%, trading at a significant premium to its 10-year average premium of 20%. However, relative P/E valuation of small-cap equities to large-cap equities is at 10% compared to a historical discount of 10%.
- Improving earnings outlook: Improving domestic growth amid favourable policy settings indicates a possible floor to the earnings downgrade cycle. Over the last 6mths, the Nifty Smallcap Index has seen consensus cut FY2025/26 EPS by over 20% compared to 7% and 5% cuts for the Nifty 50 and Nifty Midcap Index, respectively. Post the cuts, FY2024-2027 EPS CAGR for Nifty Smallcap Index is only 4% compared to 11% for Nifty 50 and 17% for Nifty Midcap. This is a sharp deceleration from the period of FY 2020-2024, where EPS grew ~20% for both large-cap and small-cap index, while mid-cap index delivered 15%. In our view, we see a relatively better outlook on earnings for small-cap and large-cap equities compared to mid-cap equities.
Overall, in our view, we are overweight equities in our foundation allocations with a continued preference for large-cap equities as the risk-reward is favourable on greater margin of safety for both valuation and earnings compared to broader markets. Nevertheless, in our view a small opportunistic allocation to small-cap equities within a diversified equity portfolio is justified given the factors mentioned. Investors should look at diversified and liquid small-cap strategies rather than stocks.
(The authors Saurabh Jain is Head, Wealth Solutions, Standard Chartered Bank, India and Vinay Joseph is Head, Investment Products and Strategy, Standard Chartered Wealth, India. Views are own)
