Smallcaps have surged 2.3x since April 2023. Why Vikas Khemani still sees India’s next multibaggers here

India’s smallcap universe has more than doubled in value since April 2023, leaving investors to confront a difficult question: after such a powerful rally, is it time to shift to largecaps? Vikas Khemani, founder of Carnelian Capital, believes the answer is no. While smallcaps are no longer cheap on trailing earnings, he argues that they remain the most direct way to participate in India’s domestic growth story, provided investors can identify the right businesses.

“Small caps are the India story,” Khemani wrote in Carnelian’s latest investor letter.

Smallcap market value has grown 2.3 times since April 2023, compared with a 1.4 times increase for largecaps. The re-rating has pushed smallcaps to 32.5 times trailing earnings, against 21 times for largecaps.


But Carnelian argues that the headline valuation gap does not capture the difference in earnings growth or business composition.

On FY27 estimates, the valuation gap narrows to 27 times earnings for smallcaps versus 20 times for large caps. On a like-for-like comparison of domestic, non-financial companies, smallcaps trade at about 30 times FY27 earnings, compared with 33 times for large caps.

At the same time, smallcaps are expected to grow profits at a 22% annual rate between FY26 and FY28, compared with 16% for large caps.

“Compare like with like, and small caps are cheaper,” Carnelian said.

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Smallcaps offer a purer domestic India exposure

The central argument is that smallcaps are more closely linked to the domestic economy than the largecap index.

Around 59% of smallcap profits come from India’s domestic, non-financial economy, including factories, hospitals, retailers and builders. For largecaps, the comparable share is 32%, with a much greater contribution from banks, global commodities and information technology.

Carnelian’s analysis of 1,594 listed Indian companies found that small and midcaps have a larger representation in healthcare, industrials, consumer discretionary and materials.

By market value, healthcare accounts for 12% of small and midcaps compared with 5% for largecaps. Industrials account for 17% versus 13%, consumer discretionary 15% versus 11%, and materials 14% versus 9%.

In contrast, financials, energy, IT and utilities account for 51% of largecaps, compared with 30% of small and midcaps.

That distinction has become more important because domestic and global businesses have been moving in different directions. Between FY23 and FY26, largecap global businesses grew revenue by just 1.8% annually, while their domestic businesses grew 12.4% annually.

Khemani also sees the strongest representation of emerging Indian themes in the smallcap universe.

None of the nine listed electronics manufacturers and none of the 13 railway companies in Carnelian’s universe are large caps. Of 15 hospital and diagnostics companies, only one is a large cap.

Small companies in these newer themes grew profits at a median annual rate of 33% between FY20 and FY26.

That, according to Carnelian, is why investors should not equate size with safety or growth. The companies that could become tomorrow’s large caps are often still found outside the large-cap index.

The advantage of smallcaps is not only that the median company has grown faster. It is also that the segment offers a much larger pool of high-growth businesses.

Between FY16 and FY26, 279 smallcaps compounded profits at more than 20% annually, compared with only 13 largecaps.

Even between FY22 and FY26, when the median smallcap grew broadly in line with the median largecap, 397 smallcaps compounded profits at more than 20% annually.

The difference is even sharper among the strongest performers. The top quartile of smallcaps grew profits by 27% annually between FY16 and FY26, compared with 18% for the top quartile of large caps.

“This is the stock picker’s market,” Carnelian said.

The market returns underline the dispersion. Since April 2023, 354 smallcaps have more than tripled, while 171 have delivered negative returns. The gap between the top and bottom deciles of smallcaps was 820 percentage points, nearly five times wider than in large caps.

That makes segment level investing less useful and company-level selection more important.

Carnelian acknowledges that the smallcap rally has not been driven entirely by earnings.

Since April 2023, the smallcap price-to-earnings multiple has risen from 18.8 times to 32.5 times. The largecap multiple has remained around 21 times.

Largecaps generated earnings growth but underwent a de-rating, limiting investor returns. Smallcap returns, by contrast, were driven to a greater extent by valuation expansion.

That creates a clear risk: smallcaps no longer look inexpensive on current earnings, and the investment case now depends on future growth.

Carnelian cited Laurus Labs as an example of why current valuations can sometimes be misleading. The stock traded at a P/E of 78 times in FY24, but earnings almost tripled over the next two years while the stock rose fourfold.

The broader argument is that a high multiple can be justified if earnings compound rapidly enough.

Consensus expects median smallcap profits to grow 26.6% annually between FY26 and FY28, compared with 18.7% for largecaps. If those estimates are achieved, Carnelian believes the smallcap valuation premium will largely disappear by FY28.

Carnelian also cautions investors against using the 21-times largecap PE as evidence that the entire largecap universe offers valuation comfort.

Around 60% of largecap FY27 profits come from financials, global commodities and IT. These sectors trade at relatively low multiples, ranging from 13 to 19 times earnings, helping pull down the headline largecap valuation.

However, the typical domestic largecap franchise trades at a far higher valuation. Among 84 largecaps with earnings estimates, 46 are domestic, non-financial companies, trading at a median 42 times FY27 earnings.

Of these, 44 trade above 30 times earnings and 21 trade above 50 times.

In Carnelian’s view, investors shifting to large caps for valuation comfort may simply be exchanging small-cap growth for either cheap global cyclicals or expensive domestic franchises.

Carnelian’s case does not ignore the risks. Smallcaps tend to fall harder during market corrections and can take years to recover. Since 2005, the Nifty Smallcap 250 has outperformed the Nifty 50 in only about half of all rolling five-year periods.

Small companies also carry higher company-specific risk, weaker balance sheets and lower capacity to absorb economic shocks. Lower liquidity and thinner free floats can amplify price movements, while popular narratives can lead investors to pay for growth before it materialises.

For Khemani, the key risk is not simply owning a small company. It is owning a poor business or one with weak management.

Carnelian’s framework focuses on five factors: a large and growing opportunity, a durable competitive moat, promoters capable of scaling the business, efficient capital allocation and strong governance.

The firm said it plans to launch the Carnelian Small Cap Mutual Fund, marking its entry into the category.

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