ETMarkets Smart Talk| Redirect fresh SIPs to largecaps if mid and smallcaps dominate your portfolio: Pradeep Gupta

Mid- and smallcap funds continue to attract strong investor inflows, but elevated valuations are making largecaps increasingly attractive from a risk-reward perspective.

Should investors redirect fresh SIP contributions towards largecaps if their portfolios are heavily tilted towards smaller companies?

In an email interview with Kshitij Anand of ETMarkets, Pradeep Gupta, Chairman & MD, Anand Rathi Share and Stock Brokers Limited, explains why largecaps offer greater valuation comfort, how investors should rebalance their equity portfolios, and which sectors could create the next generation of wealth creators in India's mid- and smallcap space. Edited Excerpts –

Q) Thank you for taking the time out. Mid-and smallcap funds have outperformed largecaps over the past year, but valuations appear to favour largecaps. Is this a potential turning point in market leadership?

A) The conditions for a change in leadership are developing, although valuation differences alone cannot determine its timing. Over the year ended September 2026, the Nifty Midcap 150 and Smallcap 250 delivered total returns of 4.6% and 7.2%, respectively, against −7.1% for the Nifty 50. This divergence has strengthened the relative valuation appeal of large caps.

However, these indices represent different businesses. Financial services account for approximately 37.5% of the Nifty 50, compared with 19.5% of the Smallcap 250. Smaller companies have greater exposure to capital goods and other businesses benefiting from investment-led growth. Consequently, sector composition influences earnings prospects, valuations and performance.

FPI net outflows from Indian equities over the past 24 months have also contributed to large-cap underperformance and lower relative valuations, given the greater FPI ownership of large-cap stocks. If FPI selling continues at the pace seen since October 2024, large-cap indices could experience further relative underperformance.

Conversely, a return to positive FPI flows would be expected to benefit large caps disproportionately for the same reason.

We see large caps offering greater valuation comfort, while selected smaller companies retain stronger growth potential. A sustained leadership shift would become more likely if large-cap earnings strengthen relative to smaller companies or investors place greater value on liquidity and earnings resilience.

For investors seeking lower portfolio risk, large caps look more attractive. Investors with longer horizons and greater tolerance for volatility can retain meaningful, selective mid- and small-cap exposure.

Q) Small-cap funds attracted ₹9,039 crore, while mid-cap funds received ₹7,835 crore in September. Given the strong investor interest, are valuations in these segments justified by earnings growth?

A) Strong inflows demonstrate investor conviction; they do not establish fair value. Together, mid- and small-cap funds attracted approximately ₹16,873 crore in September—about 44% of the ₹38,307 crore net inflows into equity schemes.

At September-end, the Nifty Midcap 150 and Smallcap 250 traded at trailing P/Es of 28.4 and 34.4, respectively, against 19.4 for the Nifty 50. These represent premiums of approximately 47% and 78%.

A premium can be justified by faster, more durable earnings growth, superior returns on capital or a different sector mix. It should not automatically be treated as overvaluation.

Equally, smaller companies do not deserve a premium merely because they are small. Strong inflows chasing a limited pool of freely traded shares can push prices ahead of fundamentals. That also increases vulnerability when flows reverse.

Our preference on valuation comfort is large caps, followed by mid caps and then small caps. Selected smaller businesses may offer superior earnings growth, but their higher valuations leave less room for disappointment. The justification must ultimately come from profits and cash flows.

Allocation across market-cap segments also depends on the investment horizon. Generally, the longer the horizon, the greater the scope to allocate a larger proportion of the equity portfolio to mid- and small-cap companies.

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Q) Should investors continue their SIPs in small- and mid-cap funds at current valuations, or consider redirecting incremental investments towards large-caps and diversified equity funds?

A) Investors should preserve the discipline of investing regularly while reviewing where their incremental money goes. Continuing a SIP need not mean maintaining the same allocation indefinitely.

The risk difference is measurable. Over the year ended September 2026, annualised daily-return volatility was approximately 13.5% for the Nifty 50, 16.2% for the Midcap 150 and 17.2% for the Smallcap 250. These are historical observations, but they illustrate the different risk profiles.

Investors whose portfolios have become disproportionately exposed to smaller companies can redirect fresh SIP contributions towards large-cap or suitably positioned flexi-cap funds. This can restore balance without immediately selling existing holdings.

Those with a seven-to-ten-year horizon, adequate liquidity and the capacity to withstand substantial drawdowns can continue measured mid- and small-cap allocations.

SIPs spread purchases across market levels; they do not eliminate valuation, business or liquidity risk. Higher exposure to smaller companies creates the possibility of higher returns, rather than an assurance. The allocation should reflect the investor’s financial capacity to bear losses as well as their willingness to accept volatility.

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Q) There is a growing talk around largecaps. Are largecaps becoming attractive because their valuations have corrected, or do they also offer better earnings visibility in the current market environment?

A) Both factors matter. Our base case is approximately 12–16% annualised earnings growth for large caps over the next two years. This is a forecast, conditional on revenue growth, margins and credit costs developing broadly as expected.

Meanwhile, valuations provide a more supportive starting point. At September-end, the Nifty 50 traded at 19.4 times trailing earnings and 2.8 times book value.

Large companies generally benefit from stronger access to finance, established distribution, diversified customers and greater capacity to absorb cost shocks. These characteristics can improve earnings resilience.

Among lenders, however, the assessment must also consider deposit costs, asset quality and returns on equity. The investment case therefore combines a reasonable entry valuation with the prospect of improving earnings. It does not require an aggressive expansion in valuation multiples to work.

We would nevertheless distinguish between earnings visibility and earnings certainty. Large caps remain exposed to commodity prices, global demand and domestic financial conditions. Our preference is based on their current balance of expected growth, valuation and risk.

Q) You track small & midcaps very closely—how much of the future earnings growth of mid- and smallcap companies is already priced in? What would it take for these stocks to justify their current valuations?

A) In our assessment, a substantial earnings recovery is already embedded in valuations,

particularly among small caps. However, the opportunity set is sharply divided: some companies have strong growth visibility, while others face weak demand, execution challenges or earnings expectations that appear ambitious.

An index average conceals this dispersion. It cannot tell us precisely how much future growth is priced into every constituent.

To justify current valuations, companies must deliver sustained revenue growth, protect margins and convert accounting profits into cash.

Capacity expansion should improve returns on capital, while order books must translate into profitable execution and collections. Growth achieved through repeated equity dilution is less valuable to existing shareholders.

Even delivering earnings growth may be insufficient if the starting valuation is excessive. As an illustration, a 20% increase in earnings combined with a 25% contraction in the P/E multiple produces a 10% fall in share price, before dividends.

Consequently, we remain interested in selected mid- and small-cap businesses, but the margin for error is limited. Earnings disappointments can hurt twice: through lower profit estimates and a lower multiple applied to those profits.

Q) For an investor starting a fresh SIP today, should largecaps form the core of the portfolio, with mid- and smallcaps playing a complementary role?

A) Yes. For a long-term investor with an appropriate capacity for equity risk, we currently favour approximately 55–60% in large caps, 20–25% in mid caps and 15–20% in small caps, with the chosen weights adding to 100%. An illustrative allocation would be 60:25:15.

Large caps provide the core because of their relative valuation comfort, liquidity and generally greater business resilience. Mid and small caps complement that core by providing exposure to emerging businesses and potentially faster earnings growth.

Implementation should consider the underlying holdings across all funds. A flexi-cap fund may already provide substantial mid- and small-cap exposure, so fund-category labels alone can misrepresent the actual allocation.

For investors with lower risk capacity, the small-cap allocation should be lower. Starting a SIP is principally about establishing a sustainable investment process; attempting to identify the next winning market-cap segment should be secondary.

Q) Should investors rebalance towards largecaps after years of mid- and smallcap outperformance, or could that mean exiting too early?

A) A modest shift from small caps towards large caps, while broadly retaining mid-cap exposure, appears sensible where smaller companies have become overweight.

The performance gap has been substantial. Over the five years ended September 2026, annualised total returns were approximately 14.8% for the Nifty Midcap 150 and 14.5% for the Smallcap 250, compared with 6.4% for the Nifty 50. Such differences can materially change portfolio weights without any deliberate allocation decision.

Rebalancing should restore the intended risk profile. It does not require confidence that smaller companies have peaked or that large caps will immediately outperform.

Investors can first redirect fresh contributions and then, where necessary, make phased adjustments to existing holdings, considering applicable taxes and exit loads. Portfolio exposure should be assessed across funds to identify overlapping positions.

There is always a possibility that the segment being reduced continues to outperform temporarily. That is an acceptable consequence of disciplined risk management.

Retaining meaningful mid- and small-cap exposure preserves participation in their growth while reducing dependence on one part of the market.

Q) Where could India's next generation of small- and midcap wealth creators emerge from: manufacturing, capital expenditure, financialisation, healthcare or emerging technology businesses?

A) We currently favour investment-led opportunities over broad exposure to goods consumption. The FY2026–27 Union Budget provides ₹12.2 lakh crore for public capital expenditure, approximately 9% above the previous year’s budget estimate. This supports a substantial opportunity set, although actual execution remains critical.

Within manufacturing, promising areas include precision engineering, electronics components, industrial automation, aerospace and defence components, and specialised electrical equipment.

In infrastructure, we would examine transmission equipment, transformers, cables, water treatment and efficient construction suppliers.

Consumer services also offer attractive possibilities: hospitals, diagnostics, hotels, organised travel and specialised education or training. Their growth can benefit from rising incomes, greater formalisation and demand for better-quality services.

Financialisation creates opportunities in asset management, wealth distribution, registrars and market infrastructure. India’s mutual fund industry managed ₹82.64 lakh crore at September-end, illustrating the scale of this ecosystem.

In technology, we prefer businesses with paying customers, defensible capabilities and a credible route to cash generation.

These are areas for identifying companies, rather than blanket sector recommendations. Sustainable wealth creation requires competitive advantage, disciplined capital allocation and a purchase price that leaves room for investors to benefit.

Q) How important are return on capital, cash-flow generation and balance-sheet strength when evaluating small- and midcap companies? Which financial warning signs would make you avoid a stock despite its growth potential?

A) They are central to the investment decision. Growth creates shareholder value when returns on newly invested capital sustainably exceed the cost of that capital. Rapid expansion with inadequate returns can destroy value despite impressive revenue growth.

For non-financial companies, we would examine returns on capital across a business cycle, cumulative operating cash flow relative to profits over three to five years, debt-servicing capacity and the funding requirements of expansion.

Warning signs include receivables or inventories persistently growing faster than sales, profits rising while operating cash flow deteriorates, repeated exceptional gains, aggressive capitalisation of expenses and unexplained accounting changes.

Persistent gaps between reported earnings and cash generation warrant particularly close scrutiny. We would also be cautious about rising promoter pledges, opaque related-party transactions, repeated dilution, auditor qualifications or unexplained auditor resignations.

Negative free cash flow during a well-funded expansion is not automatically disqualifying; the project’s economics and funding structure matter. For lenders, asset quality, capital adequacy and liquidity require separate assessment.

We would avoid a company where governance or financing risks cannot be satisfactorily explained, however attractive its growth story.

(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)