Small-caps defy market selloff: Is this the next big opportunity?

India's small-cap segment has shown remarkable resilience in recent months, outperforming broader market benchmarks despite heightened volatility and concerns around valuations. While the Nifty 50 declined around 2.5% in May, the Nifty Smallcap index was nearly flat, slipping just 0.15%.

The contrasting performance has drawn investor attention and raised an important question: what is supporting small-cap stocks when benchmarks are under pressure?

A recent study by Bajaj Finserv AMC suggests that the answer lies in a combination of improving fundamentals, healthier balance sheets, attractive valuations and expectations of an earnings recovery. According to the fund house, the small-cap universe has undergone a structural transformation over the past few years, creating conditions that may support long-term growth despite near-term market fluctuations.

"The small-cap universe has undergone a significant structural transformation in recent years. Companies are increasingly funding expansion through internal cash flows rather than borrowing, resulting in healthier balance sheets and improved profitability metrics."

Improving Fundamentals and Stronger Financial Discipline

One of the key reasons behind the relative strength of small-cap stocks is the substantial improvement in corporate fundamentals. Bajaj Finserv AMC noted that aggregate capital expenditure in the small-cap segment increased from around ₹2.2 trillion during FY19-FY22 to nearly ₹3.4 trillion during FY23-FY26. At the same time, net debt-to-equity ratios declined sharply from 0.52x in FY19 to near-zero levels in FY26.

The improvement in balance sheets has also translated into better profitability. Return on equity (RoE) across the segment rose from 9% to 12% over the same period, indicating stronger financial discipline and more sustainable business models. These developments have helped investors remain constructive on the segment even when broader markets have witnessed selling pressure.

Another positive factor has been the increasing participation of domestic institutional investors (DIIs), largely through systematic investment plans (SIPs). Such inflows are generally considered more stable and long-term in nature, helping reduce volatility and provide a consistent source of capital for smaller companies. Meanwhile, a moderation in retail ownership may have reduced speculative activity in the segment.

Market Correction Has Created Valuation Opportunities

The recent correction in equities has also improved the valuation comfort for investors looking at small-cap stocks. According to the study, nearly 50% of small-cap stocks are currently trading below their 10-year average valuations, one of the highest such readings in recent years. This broad-based correction has helped remove excessive valuations and created selective opportunities in fundamentally strong businesses.

The AMC believes that investors are increasingly focusing on companies with strong financials, consistent earnings records and sustainable competitive advantages rather than chasing momentum-driven stocks. Such an approach has helped maintain confidence in the segment despite weakness in benchmark indices.

“The study also notes that this broad-based correction has helped clear overvaluations from the market and created selective opportunities in fundamentally strong businesses.”

Historical data also supports the bullish argument for small caps. During the post-Covid recovery period between March 2020 and January 2022, the Nifty Smallcap Index surged 247%, significantly outperforming the Nifty 50, which gained 138%. This demonstrates the segment's ability to deliver sharper recoveries once market sentiment improves and economic growth accelerates.

The relative outperformance of small caps in May suggests that investors are increasingly differentiating between fundamentally strong smaller companies and broader market trends. While risks remain, improving fundamentals, supportive domestic flows and more reasonable valuations appear to be helping the segment weather market weakness better than large-cap benchmarks.

Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of Mint. We advise investors to check with certified experts before making any investment decisions.