Retail investors' most favoured small-cap stocks are at the forefront of the recent market sell-off, causing many high-flying stocks to touch multi-month lows, with some even slipping to one-year lows.
Although stocks have regained some strength in recent sessions, they are still trading at significant discounts from their recent highs. Over the last three trading sessions, the Nifty Smallcap 100 index has gained 4%, but it remains down by 6.22% in January so far.
To be precise, the index has been on a downward trend since September 2024, but the sell-off intensified this month as concerns over moderation in Q3FY25 earnings made investors cautious about this space, leading to sharp profit-booking across the board.
Post-Q2FY25 results, the majority of small-cap stocks had seen cuts in EPS, raising concerns that this trend may continue in the current quarter, as analysts project modest earnings growth for India Inc in the December quarter.
The weak projections came at a time when investors were hoping for a rebound in earnings following a lacklustre performance by corporate India during the first half of the current fiscal year.
The expectations of weak earnings, coupled with strong selling by FPIs, have also led the small-cap space to witness sustained selling pressure.
At current levels, the Nifty Smallcap 100 index is trading 10.3% below its all-time high of 19,640, which it reached in late September. Despite this notable correction, experts remain cautious about this space, as they believe the recent sharp decline has not brought valuations to comfortable levels
Kush Gupta, Director at SKG Investment & Advisory, stated that while Indian small caps have fallen more than 10% in recent weeks, they have moved in sync with the broader market, with the Nifty 50 correcting around 7% during the same time.
He explained that it is natural for small caps to underperform large caps when sentiment is down, emphasising that the issue lies with the overall market. Gupta attributed the sentiment shift to disappointing Q2 earnings and high valuations, which led to profit-booking across the board.
“Going forward, I think along with weak earnings, investors are also wary of a global slowdown and US debt. Today, US debt accounts for over 8% of their GDP, while in the rest of the world, the average is 4-4.5%. The financial world is globally connected, and investors are well-informed of the setbacks a weak US economy can bring to India.”
"Also, portfolios have outperformed all expectations for three straight years, so investor psyche has changed. They anticipate a cooldown and are in no hurry to jump in before there is clarity on certain issues. I think it’s a combination of various factors that is keeping buying at bay," Gupta added.
Vivek Sharma, investment head at Estee Advisors, stated that Q1 results were lackluster, and Q2 earnings were even worse, triggering the sell-off. By the end of the year, large-cap stocks had declined by about 10% from their peak, while small-cap stocks initially showed resilience despite concerns over valuations.
Sharma further stated that in January, the small-cap index took a nosedive, dropping about 6%. He attributed this sharp decline to high valuations, disappointing earnings expectations, and profit-booking by investors, which have collectively driven selling pressure in the segment.
Kush Gupta noted that in the calendar year 2024, the Nifty Smallcap Index delivered a return of 24%, despite a correction in December. This performance is nearly double its 10-year average return of 13.1%. From this perspective, Gupta believes valuations could trim down further.
He highlighted that high PE levels persist across most asset classes and are not confined to specific sectors but are present even in traditional businesses. According to Gupta, this indicates froth in the market, driven by domestic funds and a frenzy around small caps.
He further pointed out that the AUM of small-cap funds reached ₹3 lakh crore by the end of 2024, which is six times what it was in January 2020. Most of this growth occurred post-2022, creating visible buoyancy. Gupta emphasised that for the market to remain healthy and sustainable, the excess must be trimmed.
Vivek Sharma commented that while the recent correction has moderated valuations to some extent, the index continues to trade above its historical median PE. He observed that many investors have a short-term memory, with the recent rally causing them to underestimate the risks associated with small-cap investments.
"Historically, small caps have shown stagnation for really long periods of time. For instance, from December 2017 till April 2023, for over five long years, the index was effectively flat, delivering 0% returns. This means an investor who would have put in money at the end of 2017 would not have seen positive returns until five years later. And now, in just about a year and a half, the index has almost doubled," said Vivek Sharma.
He cautioned that corporate governance issues and sharp value declines are common among small caps and advised investors to approach this segment with caution to avoid overexposure.
Kush Gupta expressed the likelihood of another round of correction before investable opportunities emerge. He described the Indian small-cap segment as a compelling growth story that, in his opinion, will form the foundation of the country’s economic growth over the next 5–7 years.
While Gupta remains confident about the small-cap space from an asset allocation perspective, he believes that some profit-booking would help bring valuations to more reasonable levels, aligning with sustainable market growth.
Disclaimer: The views and recommendations given in this article are those of individual analysts. These do not represent the views of Mint. We advise investors to check with certified experts before taking any investment decisions.
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