Small-cap firms' Q3FY26 performance offers silver lining in equity markets

Indian equity markets present a striking paradox. Mega companies are struggling with their businesses as if India is in a recession, yet their stock prices remain firm. Scores of small firms are doing extremely well, as if the Indian economy is growing at 10 per cent or more, but their stock prices are languishing. How will this paradox be resolved? In my view, we may now see an outperformance by quality smallcap stocks and possibly continued stagnation in largecap stocks. 

The Indian equity markets have underperformed most global markets since the peak in September 2024, after an 18-month bull run. During this run, the bulls refused to be reined in even by the underwhelming performance of the ruling party in the June 2024 general elections. After a day of shock at the results, the markets resumed their upward march — until headwinds started emerging later in 2024, followed by an 18-month phase of underperformance. However, if you look at the large companies in the Nifty or CNX 500, this underperformance may not be obvious. While the Nifty was down 2 per cent between early September 2024 and late January 2026, the CNX 500 was down 5 per cent. But over the same period, the Nifty microcap index was down 17 per cent. The median returns were far worse. 

Some of the decline in small caps was justified. Many of them had become too expensive, carrying very high growth expectations aided by strong fund flows. So when the economic headwinds started blowing in 2025, expensive growth stocks were sold. These headwinds came from three sources. First, there was reduced government capex — the principal driver of the 2023-24 bull market — which was initially blamed on the 2024 elections but continued well into the following year. Second, India was hit with punitive tariffs by the United States in 2025. Third, there was a slowdown in domestic consumption due to high taxes and slow wage growth. 

Spooked by this barrage of negative news, foreign institutional investors (FIIs) sold heavily. Net outflow was nearly $23 billion in 2025 and January 2026 combined. The problem during such phases of selling is that investors tend to be indiscriminate; good stocks get punished along with the bad ones. Coinciding with continuous FII selling, the Reserve Bank of India allowed the rupee to weaken, possibly to support exporters. Since the Indian equity markets have been highly correlated with the value of the rupee, this made matters worse. Last year turned out to be the worst performance for the Indian markets in over three decades; it underperformed other emerging markets by nearly 40 per cent. In such a situation, “buyer’s strike” sets in, making markets brittle. So the market can fall sharply for no clear reason, as we saw last Thursday, when the Sensex dropped 1,400 points. 

Is there a silver lining to any of this? There is. The December quarter has given us data that is suddenly very positive. Continuing with the paradoxical price behaviour of largecap stocks (resilient) and smallcap stocks (wilting), we have just witnessed another weak quarter for Nifty 50 stocks and an excellent quarter for Nifty smallcap and microcap stocks. Sales of the Nifty 50 companies, which include megacap firms, were up 10 per cent, but they recorded zero per cent operating profit growth and only 1 per cent net profit growth. The broader CNX 500 companies recorded 11 per cent sales growth and 8 per cent growth each in operating profit and net profit, similar to BSE 250 largecap and midcap stocks (11 per cent sales growth and 7 per cent profit growth). 

However, contrary to conventional wisdom — which assumes that smaller companies do worse under economic stress because larger ones have more resources to withstand headwinds — they have done very well. The sales growth of the Nifty microcap-index companies was 12 per cent, operating profit growth 13 per cent, and net profit growth 24 per cent. The best-performing group was the Nifty Smallcap 250, which recorded sales growth of 11 cent, strong operating profit growth of 22 per cent, and a stunning net profit growth rate of 38 per cent. 

I do not know whether this will lead to a new bull market, especially in smallcap stocks, but we are probably in a situation opposite to the one we were in September 2024. Valuations are now very reasonable for many small but fast-growing companies. Their fundamentals have improved, as mentioned above. Of the 1,000 companies we track, about 200 have reported operating profit growth of 30 per cent, which is the highest number since the June quarter of 2023. There are also a few economic indicators that support this view. 

Government capital expenditure (capex) has rebounded to budgeted levels, and there is some pickup in private-sector capex as well if we go by the corporate data. The commercial-vehicle segment is doing very well, eway bills have hit new highs, and growth in bank credit remains strong. Improving fundamentals of quality smallcaps, combined with falling stock prices, make for an interesting combination. Keep your fingers crossed. 

The writer is cofounder of www.moneylife.in and a trustee of the Moneylife Foundation; @Moneylifers