Use current valuations to enter small-cap stocks with robust fundamentals

Enter only those stocks that have consistently strong financials, adequate liquidity, and no signs of corporate governance risk

A recent study by Abakkus Mutual Fund found that many small-cap stocks now trade well below their previous peaks. According to the fund house, this has created a window that investors can utilise to accumulate high-potential businesses at more sustainable valuations before the next growth cycle commences.

 

Valuations have normalised

 

Valuations have cooled meaningfully from peak levels and no longer look euphoric. “Much of the froth visible in 2023 and early 2024 has been absorbed,” says Gaurav Bhandari, chief executive officer (CEO), Monarch Networth Capital. At the index level, valuations remain slightly expensive compared to five-year averages (see table).

 

At the individual stock level, however, pricing has become more attractive. “On a forward PE basis, several quality small-cap names are available at sub-20 multiples,” says Prabhakar Kudva, director and principal officer, portfolio management service, Samvitti Capital.

 

“Nearly half the universe is trading 35–45% below their highs, which indicates that prices have corrected faster than fundamentals in many cases,” says Bhandari.

 

Positive drivers

 

Earnings have begun to recover after the recent downgrade cycle of FY25, and experts expect the trend to strengthen. “Domestic tax reforms, higher government and private spending, and easing of global trade uncertainty could support the improvement in earnings,” says Vinod Nair, head of research, Geojit Investments.

 

A revival in foreign institutional investor (FII) inflows could also lift momentum. “If tariff and geopolitical noise settles and global risk appetite returns, small caps could benefit disproportionately from improving sentiment,” says Kudva.

 

Kudva says a new theme or sector with demonstrably high earnings growth is needed to drive portfolio allocations back into this segment — a role played by manufacturing, defence, and capital goods in previous cycles

 

Stable interest rates and liquidity, along with a return of risk appetite among domestic retail and high-net-worth individual (HNI) investors, could also aid the recovery.

 

Key impediments

 

Experts point to monetary conditions as crucial factors. “Delayed rate cuts and liquidity tightening are key risks,” says Bhandari.

 

Export-centric small caps could come under pressure if global growth slows.

 

A softer domestic earnings cycle would pose another risk. “It would remove the fundamental support needed for small caps to re-rate,” says Kudva.

 

The continuation of the risk-off environment due to global uncertainties would also prevent a turnaround. “Small caps continue to trade at a premium to large caps, making them less attractive in a high-risk environment marked by AI-led business disruption, global trade uncertainty, geopolitical tensions, and elevated bond yields,” says Nair. Geopolitical uncertainty can keep foreign inflows, and therefore risk appetite, subdued.

 

Bhandari flags excess leverage in some over-owned names as a risk.

 

Should retail investors enter now?

 

Experts advise against indiscriminate buying in small caps. “Investors should focus on quality balance sheets and earnings visibility,” says Bhandari.

 

“Selective opportunities are available in domestic-focused private banks, infrastructure, real estate, capital goods, and auto,” says Nair.

 

Risks to be wary of

 

Small caps demand a high risk appetite and discipline on entry valuations. “Over the long term, small caps have seen periodic sharp corrections. Investors must be prepared for such volatility and enter only at prices that make sense from an intrinsic value perspective,” says Joseph Thomas, head of research, Emkay Wealth Management.

 

Lower liquidity remains a structural issue with many stocks within this segment, which means even modest selling can trigger sharp drawdowns. Governance and earnings risks are also higher in many smaller companies. “Investors should therefore allocate prudently and diversify adequately,” says Harsh Vira, founder, FinPro Wealth.

 

Do the due diligence

 

Experts say liquidity should be a non-negotiable screening factor. “A stock may look attractively priced, but inadequate liquidity can make entry and exit difficult,” says Thomas. He adds that promoter holding matters because a meaningful stake signals alignment of interest and long-term commitment.

 

Investors should also check regulatory compliance and assess the strength of risk management practices. Given that many business models in the segment are still evolving, investors should examine the quality of the stock’s financials over the long term. “They should evaluate earnings consistency, debt levels, cash flows, and return ratios like return on equity (ROE) and return on capital employed (ROCE) over multiple years,” says Vira. He adds that investors should assess promoter quality, pledging, and whether the company has real business expansion or enjoys only narrative-driven valuation.

 

Precautions to exercise

 

Given small-cap volatility, experts advise keeping exposure limited within the overall equity portfolio and diversifying across stocks. “Except for extremely conservative investors, most other risk profiles can consider allocating 10 to 20 per cent of their portfolio to small-cap stocks,” says Thomas. He also suggests diversifying to manage company-specific risks.

 

Vera emphasises the importance of having a clear exit strategy in case fundamentals deteriorate.

 

Post-correction advice for existing investors

 

Investors who have weathered the correction should be patient and make well-considered moves. “A bounce-back after a fall often occurs within a reasonable period, though recovery timelines vary across stocks,” says Thomas. He says investors should track sector prospects, earnings trends, and valuations because liquidity-driven rallies can make valuations expensive quickly.

 

“Where financial performance remains strong, and momentum is sustained, investors may consider selective additions,” says Thomas.

 

“Hold if fundamentals and growth outlook remain intact. Exit if earnings deteriorate or governance concerns arise,” says Vira. He adds that investors should add only when valuations look reasonable, and the long-term thesis remains intact.

 

(The writer is a Mumbai-based independent journalist)