Small caps move into stock-specific phase after sharp swings

markets

• Small-cap stocks now need selective picking and investor patience
• Small caps still trade at a premium despite valuation corrections.
• Fund managers see opportunities in manufacturing and tech sectors

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Small-cap stocks, after witnessing both euphoria and steep corrections in recent years, are entering a phase where selective stock picking and patience will determine outcomes, fund managers said at the Moneycontrol Mutual Fund Summit in Ahmedabad. With valuations having corrected from elevated levels and earnings momentum moderating, the broad-based rally seen earlier is giving way to a more discerning market environment.

Chandraprakash Padiyar, Senior Fund Manager at Tata AMC; Ihab Dalwai, Senior Fund Manager at ICICI Prudential AMC; and Cheenu Gupta, SVP, Fund Management Equities at HSBC Mutual Fund, speaking at the summit, said the extraordinary run between 2020 and 2024 was driven by low base effects and liquidity, but the next few years will require sharper bottom-up selection.

From Broad Rally to Bottom-Up Discipline

Padiyar said the 2021 to 2024 period was unusual as earnings across the small-cap universe rebounded from a low base, leading to widespread gains. Valuations, he said, became extraordinarily high in 2024, prompting Tata Small Cap Fund to stop taking lump-sum flows from June 2023 and maintain a conservative stance over the past two years.

Following the recent correction, he said there are businesses available that can grow earnings at a fast pace, with valuations now more reasonable though not cheap. While stock selection was not critical during the earlier broad rally, the next three to four years will require bottom-up stock picking, he said.

Dalwai said that although valuations have corrected and the euphoria seen in 2024 has subsided, small caps continue to trade at a premium to large caps. Historically, there were periods when small caps traded at a discount, but that is no longer the case. From a bottom-up perspective, he said opportunities continue to exist, particularly in sectors where leaders themselves are small caps, including segments within auto, real estate and manufacturing. However, he said small caps should form a part of a portfolio rather than its core.

Gupta said stock selection is critical in small caps and cautioned against focusing solely on near-term earnings growth. The key, she said, is to assess whether a company can grow sustainably over a three to five-year period. Scalability is more important than one-year earnings growth. She said investors should evaluate the quality of earnings, management discipline in capital allocation and the ability to build management bandwidth beyond promoters. The objective is to identify small-cap companies that can evolve into mid-cap businesses over time.

Valuations, Flows and Sectoral Pockets

Dalwai said that at an index level, small-cap performance may not fully capture the success of individual companies, as those that perform well often graduate to mid-cap indices. However, he noted that the success ratio in small caps is lower compared to large and mid caps. Valuations remain at a premium and earnings momentum is moderating. Mutual fund inflows into the small-cap category have remained between Rs 40,000 crore and Rs 50,000 crore annually over the past two years, indicating sustained investor interest.

Padiyar said that within the Rs 5,000 crore to Rs 15,000 crore market capitalisation band, there are over 400 companies to choose from. Within this universe, he said companies are available at 10 to 15 times price-to-earnings multiples, with cash flow generation, expected earnings growth of over 20 percent and return on capital employed close to 20 percent. He pointed to precision engineering, auto engineering, capital goods and manufacturing businesses, particularly those investing in research and development and securing patents, as areas where scalability could be significant.

Gupta said that after the September 2024 peak, the market has seen both price correction and time correction, leading to more cautious sentiment. Small-cap investing, she said, requires patience of two to three years. She highlighted manufacturing, export-oriented companies and businesses leveraging technology to scale as potential areas of opportunity. Technology, she said, has reduced traditional barriers between large and small companies, enabling smaller firms to expand distribution and operations more effectively.

The fund managers said the next phase for small caps will be driven less by liquidity and more by company-specific fundamentals, with disciplined stock selection and patience central to returns.