Reasonable valuations, earnings revival to aid small-cap funds in 2026

After underperforming in 2025, small-cap funds may see a turnaround as valuations become more reasonable and earnings revive; existing investors should stay invested, while new ones enter gradually

Small-cap funds delivered a return of -5.5 per cent in 2025, marking a phase of underperformance after two years of strong gains in 2023 (43.4 per cent) and 2024 (26.3 per cent). Investors with a long-term horizon should not throw in the towel at this stage.

 

“Periods of underperformance often create attractive entry points. Leadership in Indian equities has historically emerged from such phases when backed by domestic growth drivers,” says Ajay Khandelwal, fund manager, Motilal Oswal Asset Management Company.

 

Why small caps underperformed 

In 2024, the central government and the Reserve Bank of India (RBI) implemented a series of fiscal and monetary tightening measures to rein in inflation and stabilise the rupee against the US dollar. While these steps achieved their objective, their impact on growth emerged with a lag. Consumer demand weakened and corporate earnings growth slowed through 2025. The slowdown hurt the small-cap universe the most. “With valuations high and earnings declining, stocks had to correct to adjust for the dip in earnings,” says Dinshaw Irani, managing director and chief executive officer, Helios India. 

“Earnings failed to meet expectations, particularly among capital goods, consumption-linked and export-oriented smaller companies,” says Arihant Bardia, chief investment officer and founder, Valtrust.

 

International developments also played a part. “Global uncertainty, volatile capital flows, and a broader shift towards risk aversion also contributed to the underperformance,” says Shweta Rajani, mutual fund head, Anand Rathi Wealth.

 

Earnings outlook turning supportive 

The earnings outlook for small-cap stocks has begun to improve. From late 2024 onwards, both the government and the RBI reversed tightening measures, easing liquidity and lowering borrowing costs. This has supported a recovery in demand and a revival in earnings momentum.

 

“When NSE500 earnings for the September 2025 quarter are broken down by market capitalisation, small-cap companies recorded the fastest earnings growth,” says Irani. A low base is likely to help this segment deliver higher growth rates in 2026.

 

“Broad-based earnings recovery could happen as operating leverage kicks in, margins stabilise, and domestic demand remains resilient. The ongoing capital expenditure cycle in infrastructure, manufacturing, defence and renewables continues to create multi-year growth opportunities for smaller companies,” says Bardia. Structural tailwinds from Make-in-India initiatives and global supply-chain diversification strengthen the medium-term outlook of the small-cap segment.

 

“For the full year, earnings growth is expected to normalise in the 10–12 per cent range,” says Rajani.

 

Some estimates for the small-cap universe are higher. “Against expected NSE500 earnings growth of 12–15 per cent, small caps are expected to clock a growth rate of 22–25 per cent,” says Irani.

 

“Future returns are more likely to be driven by earnings delivery rather than multiple expansion,” says Rajani. This reduces downside risk and improves the probability of more stable and sustainable returns over the next market cycle.

 

“A potential tariff agreement with the US and a stable rupee could further lift sentiment and encourage foreign portfolio investor inflows,” says Irani.

 

While near-term volatility may persist, 2026 could mark the beginning of a recovery phase. “Domestic flows through systematic investment plans (SIPs) continue to provide a strong structural cushion, reducing the probability of sharp, prolonged drawdowns,” says Khandelwal.

 

Valuations more reasonable 

After the correction and consolidation in 2025, valuations have moderated. The small-cap universe is now trading at price-to-earnings (P/E) multiples in the mid-twenties. While still above long-term averages, valuations are no longer euphoric and look reasonable relative to expected earnings growth, which is higher than that of large- and mid-cap companies.

 

External risks 

Potential risks remain in the small-cap segment. “Key risks include a potential global slowdown that could affect exports and order inflows, delays in private sector capex if global conditions weaken, and sharp risk-off episodes that tend to impact small caps disproportionately due to liquidity constraints,” says Bardia.

 

Irani points out that demand revival following GST rationalisation could falter, though he adds that the likelihood of this happening is low, as consumption has recovered only recently. Bardia adds that investor fatigue after a disappointing 2025 could lead to moderation in retail participation and SIP flows in the near term.

 

Align allocation with risk appetite 

Allocation to small-cap funds should be aligned with an investor’s risk appetite and time horizon, given the segment’s higher volatility. Bardia suggests that for moderate-risk investors willing to stay invested for at least three to five years, an allocation of around 10–20 per cent can be appropriate.

 

“A balanced equity mix of roughly 55:25:20 across large-cap, mid-cap and small-cap funds helps maintain stability and liquidity while capturing growth potential from mid and small caps,” says Rajani.

 

Exposure should ideally be built gradually through staggered investments rather than lump-sum deployment.

 

Mistakes to avoid 

One of the biggest mistakes in small-cap investing is entering with a short time horizon and expecting quick returns. Investors also tend to overexpose themselves based on past momentum. “Chasing performance during strong phases can lead to entry at elevated valuations, increasing the risk of drawdowns during market corrections,” says Rajani.

 

Fund selection is equally critical. Irani warns against opting for funds where managers prioritise earnings growth but overlook management quality, corporate governance and clean accounting.