Small, microcaps offer better alpha opportunities; midcaps look expensive: Equitree CIO Pawan Bharaddia

Indian equities may remain supported by a resilient domestic economy, but the next leg of market returns is likely to be driven more by earnings delivery than another round of broad-based re-rating, according to Pawan Bharaddia, Co-founder and Chief Investment Officer at Equitree Capital Advisors.

Bharaddia sees select small and micro-cap companies, particularly in the Rs 1,000–5,000 crore market-cap range, offering greater potential for alpha, while broad mid-cap valuations leave relatively little room for disappointment. Large caps, meanwhile, offer greater stability and earnings visibility.

In an interview, Bharaddia discusses where valuations still offer opportunities, the emerging earnings recovery, sectors that could outperform, risks around expensive capex and AI-related themes, and how investors should position portfolios over the next 6–12 months.


Edited excerpts from a chat:


What is your base case outlook for Indian equities over the next 6–12 months, and which factors could materially alter that view: earnings, interest rates, global liquidity, crude oil or geopolitics?

Our base case is constructive on Indian businesses, but measured on the broader market. We do not believe the next 6–12 months will be a period where simply owning the market generates outsized returns. The phase of easy multiple expansion is largely behind us. From here, returns should increasingly be driven by earnings delivery, which means dispersion between companies is likely to remain high.

The domestic macro backdrop remains reasonably supportive. The RBI has raised its FY27 GDP growth estimate to 6.7%, retained the repo rate at 5.25% and moderated its inflation forecast to 5%. Corporate balance sheets are also relatively healthy and credit growth has accelerated. These factors provide a reasonable foundation for earnings.

At the same time, the biggest external swing factor for India remains crude. Brent is currently around $88 per barrel. Sustained crude closer to or above $95–100 would be materially negative through four channels: inflation, the current account, the rupee and corporate margins. This is consistent with our view through the recent West Asia volatility. Conversely, a durable geopolitical de-escalation accompanied by crude moving sustainably lower would improve the outlook meaningfully.

Global liquidity is relevant, but we would not build an investment thesis around it. Foreign investors returned with about $2.1 billion of net equity purchases in July, but remain significant net sellers for the year. Domestic credit and liquidity conditions are presently more supportive, so global flows are more likely to amplify market movements than determine India’s underlying earnings trajectory.

The factors that would make us more constructive are a broader earnings upgrade cycle, lower crude, improving private capital expenditure and continued strength in domestic demand. We would turn more cautious if earnings estimates start getting cut despite elevated valuations, or if higher crude and currency weakness force a materially tighter monetary environment.

In short, we are not bearish on India, but we are also not underwriting another broad-based re-rating. The next phase should be much more about earnings than liquidity.

Are current index valuations adequately supported by corporate earnings growth and India’s macroeconomic fundamentals, or is the market still pricing in an overly optimistic recovery?

India deserves to trade at a premium because the structural backdrop remains strong. The economy is growing, corporate balance sheets are generally healthy, the banking system is in a far better position than a decade ago, public investment remains strong and several manufacturing ecosystems are gaining competitiveness globally.

But a good macro story does not automatically make every valuation reasonable.

Our own work as of June 30 illustrates this quite clearly. In our universe, excluding BFSI, the median large-cap company was trading at roughly 32.1x FY27 estimated earnings versus a ten-year median of 29.2x. Mid-caps were at 38.5x versus 38.4x historically. Small caps were around 32.9x versus 33.4x, while micro caps were at 22.2x versus a ten-year median of 23.7x.

This tells us two things. First, the market as a whole is not obviously cheap. Second, the valuation opportunity has become much more stock-specific and, in our view, has shifted further down the market-cap curve.

Even within these segments, averages hide considerable dispersion. Around 69% of the mid-cap universe in our analysis still traded above 30x trailing earnings, as did about 60% of small caps. At the same time, only a small proportion of companies combined valuations below 20x earnings with PAT growth above 20%.

So we would not describe the market as being in a bubble, but neither would we say valuations provide a large margin for disappointment.

India’s fundamentals support a valuation premium. They do not support paying any price for growth. The burden of proof has now shifted from the macro narrative to actual earnings.

Where do you currently see the best risk-reward across large, mid- and small caps? Which segment offers the strongest margin of safety?

We would be careful about making a blanket large-cap versus small-cap call because the dispersion within each segment is now larger than the differences between the segments.

Large caps offer stronger liquidity, more predictable businesses and generally better earnings visibility. Their risk-reward has improved considerably from the extremes seen elsewhere in the market, but in our analysis they are still not particularly cheap relative to their own history.

The broad mid-cap segment is where we would currently exercise the most valuation discipline. Median valuations remain high, median PEG ratios in our work remain above 2, and nearly seven out of ten companies in our analysed mid-cap universe were trading above 30x trailing earnings.

We continue to find the most interesting mispricing opportunities in select small and micro-cap businesses, particularly in the ₹1,000–5,000 crore market-cap range. That does not mean small caps as an asset class are cheap. It means this part of the market contains more businesses where the gap between current price and long-term earnings potential can still be meaningful.

The distinction is important. We are not looking for inexpensive companies because they are small. We are looking for businesses capable of compounding earnings at 20% plus, with strong balance sheets, capable management, improving competitive positions and sensible valuations. Our investment framework has always been closer to growth private equity in public markets than conventional small-cap investing.

Large caps currently offer stability; select small and micro caps offer greater potential for alpha. Mid-caps, broadly speaking, appear to offer the least obvious valuation arbitrage today.

The strongest margin of safety, however, comes from the individual business and the price paid, not from its market-cap classification.

How broad-based is the emerging earnings recovery? Are profit upgrades extending beyond a handful of sectors, or does the market remain dependent on a relatively narrow set of companies?

We would describe the earnings recovery today as broadening, but not yet broad-based.

That is an important distinction.

The Q1 FY27 numbers have been better than feared. A review of 838 listed companies showed aggregate revenue growth accelerating to 22% year-on-year from 13% in the preceding quarter. Some of that growth was driven by commodity and bullion inflation, so the headline should not be read in isolation. Aggregate profitability was also distorted by weakness in oil refining. Excluding oil and gas, however, operating margins were stable at around 19% and net profit grew by more than 20% year-on-year.

There are also signs that the underlying corporate position is improving. Roughly two-thirds of the 116 sectors analysed showed an improvement in interest coverage. Consumption-linked categories including autos, FMCG, consumer durables, apparel and retail reported healthy demand. Chemicals have begun showing early signs of cyclical improvement.

But the recovery is clearly not uniform. IT services remain soft, certain export-oriented businesses continue to face demand pressure, and sectors such as cement, sugar, oil refining and aviation have faced different combinations of weak pricing or cost pressure.

This is broadly consistent with the view we expressed earlier in the year. We expected earnings to strengthen through FY27 but did not expect every company or sector to participate equally. The Q1 data makes us somewhat more constructive on the breadth of the recovery, but we would still distinguish between an improvement in aggregate earnings and a true broad-based earnings-upgrade cycle.

For markets, upgrades matter more than reported historical growth. If management commentary over the next two quarters begins translating into wider FY27 and FY28 earnings upgrades, that would be one of the strongest signals that the market can move into a healthier phase.

Which sectors or investment themes could outperform over the next 6–12 months, and which popular market narratives appear vulnerable to earnings disappointments?

We prefer thinking in terms of structural business themes rather than sector allocations.

The areas we continue to find interesting are import substitution, Indian manufacturers gaining global market share, infrastructure and industrial ancillaries, businesses gaining domestic market share, and select consumption opportunities. These are the same underlying themes we have been investing around for several years, rather than tactical calls created by the current environment.

Within manufacturing, we particularly like businesses where India is becoming structurally more competitive rather than merely benefiting from a temporary tariff or subsidy. Export manufacturing, localisation of previously imported products, rising engineering capabilities and increasing customer diversification can create very long earnings runways.

We are also seeing early improvement in chemicals after an extended period of weakness, although the recovery remains uneven. Select auto ancillaries can benefit from higher content per vehicle, exports and market-share gains. Infrastructure remains structurally attractive, but we would increasingly distinguish between the companies executing profitably and those simply carrying large order books.

Where we are more cautious is on narratives where the structural story is right but the valuation already assumes near-perfect execution.

Our June valuation work showed capital goods trading at roughly a 26% premium to their ten-year median valuation, electricals at more than a 50% premium and power at roughly an 85% premium. That does not make these sectors unattractive structurally, but it materially raises the earnings hurdle required to generate attractive shareholder returns.

AI and data centres are another example. The investment cycle is real and likely to be multi-year, but parts of the market are already capitalising several years of growth today. We would rather wait for a price that provides a margin of safety than buy simply because the addressable market is large.

Conversely, IT currently screens relatively inexpensive against its own history in our valuation work, but that alone does not automatically make it attractive. If AI creates structural changes to pricing, labour intensity or traditional outsourcing economics, a lower P/E may be reflecting genuine uncertainty rather than mispricing.

The biggest investment mistake in this phase may be confusing a good theme with a good investment. A structural opportunity can last ten years, but if five years of that growth is already embedded in today’s valuation, shareholder returns can still disappoint.

Capital expenditure, manufacturing, infrastructure and defence remain prominent structural themes. How can investors distinguish durable earnings opportunities from stocks where the narrative is already fully priced in?

The capex story itself is real. Government capital expenditure increased 24% year-on-year to approximately ₹3.4 lakh crore in Q1 FY27, equivalent to roughly 28% of the full-year budgeted target. The FY27 Union Budget has provided for ₹12.2 lakh crore of public capital expenditure, while project announcements remain strong in areas such as railways, defence, electronics, data centres and other manufacturing ecosystems. Private capex, however, remains more selective than the headline narrative sometimes suggests.

The mistake is to conclude that because the capex cycle is structural, every company exposed to capex deserves a structural premium.

We would apply six filters:

* Order-book quality over order-book size. What are the margins, execution timelines, counterparties and cancellation risks? A ₹10,000 crore order book is of limited value if it cannot be converted into profitable cash flow.

* Cash conversion. Revenue and reported PAT should eventually translate into operating cash flow. Rapid growth accompanied by continuously expanding receivables and working capital deserves scrutiny.

* Incremental return on capital. Capacity additions matter only if the next rupee invested generates attractive returns. We focus on incremental ROCE, not merely headline capacity growth.

* Balance-sheet strength. The best businesses can fund a meaningful part of their growth internally. Excessive leverage or repeated equity dilution can transfer much of the economics away from existing shareholders.

* Competitive advantage. We prefer businesses gaining market share because of technology, manufacturing capability, cost advantages, customer relationships or localisation. Dependence purely on a policy incentive is a weaker competitive moat.

* Valuation versus the duration of growth. Ultimately, price determines return. We look at the earnings growth required to justify today’s valuation and ask how many years of near-perfect execution the market is already assuming.

This last point has become particularly important because some of the most popular capex-linked sectors now trade at substantial premiums to their own historical valuations.

At Equitree, the discipline has always been to buy businesses when growth and valuation work together. We would rather miss the first part of a popular theme than own a company where the valuation leaves no room for an execution mistake.

The durability of the theme should be assessed through the P&L, balance sheet and cash-flow statement. The attractiveness of the investment should then be assessed through the price. They are two separate questions.

How should investors approach asset allocation at this stage of the cycle? What role should equity, debt, gold and cash play, and which indicators should trigger portfolio rebalancing?

Asset allocation should primarily be a function of an investor’s liabilities, time horizon and ability to tolerate drawdowns, rather than a short-term forecast of where the Nifty will trade six months from now.

For long-term capital, equity should remain the primary compounding asset, but this is a phase to raise the bar on what one owns rather than simply increase exposure because markets are rising. Earnings visibility, balance-sheet strength and valuation discipline matter considerably more today than they did when liquidity was driving almost every part of the market higher.

Debt has an important role as a source of liquidity. With the repo rate at 5.25% and the ten-year government bond yield recently around 6.78%, high-quality fixed income again offers meaningful carry. At the same time, we would be cautious about treating duration as a one-way bet because crude-driven inflation can change the interest-rate path relatively quickly.

Gold remains useful as portfolio insurance, particularly against geopolitical risk, currency volatility and extreme macro outcomes. We would see it primarily as a diversifier rather than an asset whose recent momentum should be extrapolated indefinitely.

Cash is optionality. We do not regard holding cash as a bearish market call. For an equity investor, cash should be deployed in a staggered manner to take advantage of volatility.

This is particularly useful in small and micro caps because periods of volatility can create disproportionately attractive entry prices. The ability to be a buyer when the market is panic selling can materially improve long-term IRRs.

For rebalancing, we would watch a combination of earnings revisions and valuations, rather than index levels alone. The most useful indicators today are the breadth of earnings upgrades versus downgrades, forward valuations relative to achievable earnings growth, crude oil, inflation and RBI policy, the rupee and foreign flows, credit growth, private-capex activity and the extent to which individual asset weights have moved away from an investor’s long-term allocation.

A 10% market correction by itself is not a reason to reduce equity. Equally, a 20% rally is not by itself a reason to add. What matters is whether the relationship between price, earnings and expected return has changed.

Our broad philosophy is simple: use debt for stability, gold for insurance, cash for optionality and equity for long-term compounding. Rebalance when expected returns change materially.