Smallcap valuations have moderated; understand the risks before you enter

The performance of these funds will hinge on a strong earnings recovery

A recent report from Bajaj Finserv Asset Management Company (AMC) asserts that this may be a good time for investors to enter smallcap funds. The fund house cites improving fundamentals, moderated valuations, the possibility of earnings recovery, and the segment’s tendency to outperform during recovery phases. 

Smallcap funds rallied sharply between 2020 and 2024, but started underperforming from October 2024. This phase continued until the first half of 2026. The category has gained 6.3 per cent over the past three months. 

Valuations turning reasonable 

Valuations have moderated meaningfully from their 2024 peak and now appear more reasonable in several pockets. 

“Smallcap valuations are at about 21 times one-year forward price-to-earnings ratio, broadly in line with the long-term historical average,” says Trideep Bhattacharya, president and chief investment officer (CIO) - equities, Edelweiss Mutual Fund. 

Some pockets, however, still trade at a premium. “Current valuations appear supported by financial year 2025-26 (FY26) earnings growth in the higher teens, but the margin of safety is thin and entry needs to be disciplined,” says Vinayak Magotra, product head and founding team, Centricity WealthTech. He adds that the correction has brought smallcaps back to fair value at best, not into deep-value territory. 

“Valuation dispersion remains high, making stock selection and active management critical,” says Aparna Shanker, CIO - equity, The Wealth Company Mutual Fund. 

Earnings recovery holds the key 

A recovery in earnings growth remains the most important catalyst for smallcaps. “Earnings are expected to improve as domestic demand strengthens and operating leverage begins to play out across several sectors,” says Sorbh Gupta, head of equities, Bajaj Finserv AMC. 

Earnings stagnation and contraction have historically been followed by strong earnings acceleration. “Early signs suggest such a recovery may be taking shape,” says Bhattacharya. 

Shanker, too, is of the view that improving domestic demand and rising capacity utilisation across industries could support smallcap earnings growth. 

Fundamentals offer support  

The segment’s fundamentals are sound. “Many small-cap companies have healthy balance sheets and are entering this phase with stronger fundamentals than in previous cycles,” says Gupta. The Bajaj Finserv AMC report points out that the smallcap 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.  

Gupta says that several smaller companies are well placed to gain from capital expenditure (capex)-led activity and from their presence in the power and capital goods value chains. 

“Smallcap businesses linked to manufacturing, infrastructure, defence, industrials, and domestic consumption continue to enjoy strong structural tailwinds,” says Shanker. 

Performance is, however, likely to be selective. “The present environment is more about identifying businesses with strong earnings potential, healthy balance sheets, and sound governance standards,” says Gupta. 

Considerable risks  

A weaker-than-expected earnings recovery could delay a re-rating of the smallcap segment. “If revenue growth and earnings recovery fall short of expectations, smallcap valuations could face further pressure through multiple de-rating,” says Bhattacharya. 

Global uncertainty, interest-rate volatility, a sharp slowdown in major economies, and commodity price volatility could weigh on risk sentiment and capital flows. 

A possible escalation in the US-Iran conflict and US policy uncertainty ahead of the midterm elections could trigger market volatility. 

“Crude oil remains a critical variable for India because rising inflation can squeeze margins across sectors and weigh on future earnings growth,” says Magotra. 

Tighter liquidity conditions or a further surge in crude oil prices could hurt smaller companies more than larger peers because smaller companies have weaker pricing power. 

“Disappointment in consumption recovery, delays in private-sector capex, or unexpected inflationary pressures could weigh on smaller businesses,” says Shanker. She adds that smallcaps are more sensitive to risk-off environments as they have lower liquidity and higher earnings volatility than largecaps. 

Check suitability before investing 

One prerequisite for investing in small-cap funds is to already have a well-diversified core portfolio. 

Smallcap funds suit investors with a relatively high risk appetite. Shweta Rajani, head - mutual funds, Anand Rathi Wealth, says investors must remember that small caps show high peaks and deep troughs.  

“Investors should enter smallcaps only if they can sit through 30-40 per cent drawdowns without redeeming for a few years,” says Magotra.  

Investors seeking long-term wealth creation through small caps must stay invested through market cycles. Rajani recommends an investment horizon of at least 7-10 years.  

“Investors who lack patience and may sell during market downturns should avoid these funds,” says Raghvendra Nath, managing director, Ladderup Asset Management. 

Those saving for near-term needs, such as a child’s education, a wedding, or an emergency fund, should avoid them. Retired investors and those who need income from their investments will also not find this category suitable. 

Start with small allocation 

First-time investors should make a small start. “They may allocate around 10-15 per cent of their equity portfolio to smallcap funds,” says Nath. 

A long horizon is a must. “Trying to enter and exit smallcaps over two to three years can increase the likelihood of unsatisfactory outcomes,” says Anand K Rathi, co-founder, MIRA Money. Rajni, too, recommends investing through troughs to benefit from the eventual recovery.

 

New investors should invest gradually through systematic investment plans (SIPs) instead of committing a large sum at once.

“SIPs can help investors navigate volatility and average out purchase costs over time,” says Shanker. 

Investors should examine portfolio quality and investment style. “They should select a diversified fund, avoid overly concentrated portfolios, and prefer quality-oriented smallcap funds,” says Rathi. 

Nath recommends reviewing the fund manager’s track record over several years and across market environments, and not only during strong markets. 

Existing investors should stay invested 

Existing investors with a time frame of more than five years should hold steady rather than react to recent underperformance. “Selling after poor performance only locks in losses and may cause investors to miss the rebound,” says Nath. 

Rajani suggests staying the course with systematic investment plans and not stopping investments during corrections. 

“Investors with very high smallcap exposure should gradually reduce that weight through rebalancing,” says Rajani.   

 

The writer is a Mumbai-based independent journalist