Attractive valuations, improving earnings: Why fund managers are now raising their exposure to small-cap stocks

For the past decade, midcap stocks have ruled the performance charts, outpacing both large caps and small caps. The Nifty Midcap 150 TRI (total return index) clocked an annualised return of 18.6% over the past 10 years, compared to the Nifty Smallcap 250 TRI’s 15.7%. It was more rewarding to invest in mid caps than small caps. But now, a quiet shift could be underway within Indian equity markets. Could the recent resilience of small caps signal a longer runway of outperformance? Cues may already be visible in the positioning of some flexi-cap funds.

Flexi-cap funds bet big

A clear shift in stance favouring small-cap stocks is evident in many flexi-cap fund portfolios. Even as these funds retain their bias towards large caps, they have gradually earmarked more to small caps: the average allocation to this latter basket has grown from 12.7% in March 2023 to 19.3% in April 2026.

According to Value Research data, 25 flexi-cap funds raised their small cap exposure in this three-year period. Eleven funds demonstrated a mid-to-small rotation: small-cap weights rose while midcap weights fell over the same period.


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Comparatively, the average mid-cap allocation of flexi-cap funds has hovered between 18% and 20% over these years. Sixteen funds have reduced mid-cap exposure over the past three years. Navi Flexi Cap Fund has shown the most aggressive rotation, with its small-cap exposure jumping 29.24 percentage points alongside a 5.98 percentage-point cut in mid-cap allocation.

ICICI Prudential Flexi Cap Fund is among the larger funds that have shifted their portfolios materially towards small caps: its exposure to this basket has spiked from 8.3% to 27.8% over the past three years, while its mid-cap allocation fell by 8.8 percentage points during this period.

Rajat Chandak, Senior Fund Manager at ICICI Prudential AMC (asset management company), who manages the scheme, insists this is not a conscious shift but an outcome of pure bottom-up stock selection. “Coincidentally, we found more interesting businesses in the small-cap space. A lot of unique businesses are only available in this basket.”

The Wealth Company AMC, which launched its flexi-cap fund in October last year, has bet big on small caps in recent months. Its small-cap allocation stood at 35% this March, before easing to 30.6% in April. Aparna Shanker, Chief Investment Officer–Equity, The Wealth Company, maintains that the risk-reward position is currently most favourable in small caps, followed by large caps and then mid caps. “We like to be agile in our marketcap allocation, in response to market conditions. We have consciously waded into small caps as we like taking higher active weights in pockets that are offering higher potential risk-adjusted alpha.”

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Abakkus Mutual Fund, which also launched a small-cap fund apart from a flexi-cap fund as its first two equity offerings, has taken a hefty 33.6% allocation to small caps in the latter.

What has changed

For many years, mid caps enjoyed a ‘sweet spot’ of earnings growth and quality. Midcap companies matured significantly during this period, displaying higher earnings quality that led to a sharp re-rating of price-to-earnings (P/E) multiples. Small caps, by contrast, contained a much larger proportion of cyclical businesses, lower-quality balance sheets, fragile earnings, and weak governance.

As a result, a significant portion of the small-cap universe failed to consistently participate in earnings growth. While small caps also rallied sharply post 2020, wealth creation in this space was driven mostly by P/E expansion rather than earnings growth, unlike in mid caps.

But the story may be taking a turn. While the structural issues certainly haven’t disappeared, there is growing evidence that a significant portion of the small-cap universe has become fundamentally stronger than it was during earlier cycles such as 2007-08 or 2017-18.

A study by Bajaj Finserv AMC suggests the small-cap universe has undergone a significant structural transformation in recent years. Net debt-to-equity levels declined sharply from 0.52 times in 2018- 19 to near-zero levels in 2025-26. During the same period, return on equity (ROE) improved from 9% to 12%, reflecting stronger financial discipline and sustainable business models. A 12% ROE is not extraordinary, but the direction matters. “Companies are increasingly funding expansion through internal cash flows rather than borrowing, resulting in healthier balance sheets and improved profitability metrics,” the fund house mentions in a note.

Further, the market correction over the past two years has removed most of the froth from the small-cap space. While mid caps have also witnessed a correction, experts insist there is still some way to go.

To be sure, PE multiples suggest that small caps are now more expensive than mid caps. The Nifty Midcap 150 index trades at 28.6 times trailing earnings, compared to the Nifty Smallcap 250 index’s P/E of 33.4. However, P/E multiples for the small-cap index often give a distorted picture as the profit pools within the basket are erratic. Price-to-book value (PBV) offers a more accurate reading of valuations. On PBV, the small-cap index trades at a softer multiple of 3.7 times compared to the mid-cap index’s 4.6 times.

Mid caps have ruled the charts in the past

Regulatory hurdle

There is another big reason why fund managers are not convinced they can find meaningful alpha in the mid-cap space: the tight regulatory boundaries that govern where mid-cap funds can invest.

As per the Securities and Exchange Board of India’s (Sebi) regulations, companies ranked between the 101st and 250th positions in terms of market capitalisation are classified as mid-cap companies. Mid-cap funds are required to park at least 65% of their corpus in these 150 stocks. All the money flowing into midcap funds ends up chasing a select set of 40-50 stocks from this basket. Meanwhile, Sebi defines small-cap companies as those ranked beyond 250th in market cap. This provides a broader investable universe for fund managers to pick from as they seek to deliver alpha.

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Dinesh Balachandran, Head–Equity, SBI Funds Management, recently told ET Wealth in an interview, “Mid cap is a very narrow lane and a lot of people are trying to get into it. Imagine the chaos that it’s creating in terms of valuations. Even adjusted for the higher growth potential of many mid-cap stocks, it just feels like there’s too much froth. And that is largely a function of the space being defined very narrowly and a lot of money chasing a few names.”

Coincidentally, the outperformance of mid-cap funds has sharply moderated in recent years. Actively managed mid-cap funds have started to underperform their benchmark indices more consistently than ever before. An ET Wealth analysis of mid-cap fund returns last year showed that only 18% outperformed across the three-year, five-year, and 10-year periods ending between September 2023 and May 2025, compared with 65% until 2019.

Data from StatLane, a Sebi-registered research analyst, also show that midcap is the only fund category to have underperformed the index over the past three, five, and 10 years. They have underperformed the index by 77 and 116 basis points (bps), respectively, over the past five and 10 years (100 bps is equal to 1 percentage point). Comparatively, smallcap funds have outperformed the index by 163 bps and 190 bps in these time frames, respectively.

Balachandran finds greater comfort building a portfolio of small caps, where he can afford to be more of a stock picker. According to him, “Small caps are a much more heterogeneous space, covering a wide variety of companies. I can very easily be negative on small caps and still find 10 small-cap companies I like. You can easily say that I dislike the index, but still have your portfolio geared towards small-caps.”

In June 2023, SBI Flexi Cap had over 20% invested in mid caps, as against 8.7% in small caps. Now, it has nearly 15% parked in both segments.

Mid cap funds have lagged index sharply
Outperformance/Underperformance (basis points).

Several flexi cap funds have hiked small cap exposure

Source: Value Research

Drawdowns are more frequent and magnified in small caps

Don’t get adventurous

There appears to be growing confidence among fund managers to foray into the small-cap space.

Bajaj Finserv AMC insists in its note that small caps may be “approaching a favourable entry point”, citing improving fundamentals, a potential earnings recovery, softer valuations and historically strong rebound patterns. The fund house further observes that nearly 50% of small-cap stocks are now trading below their 10-year average valuations after the recent correction. This wipe-off of valuation excesses, coupled with earnings growth and other contextual factors, has created “selective opportunities in fundamentally strong businesses”, it observes.

However, investors must be cognizant of the risks in the smallcap space. It must be noted that the hints of transformation are selective rather than universal.

The chasm between high- and low-quality small caps has widened considerably. Today’s opportunity in small caps is more about identifying businesses that have genuinely evolved into durable compounders. The rebound in small-cap stocks will not play out evenly. “Earnings have to catch up meaningfully before we can expect re-rating in these stocks,” avers Shanker of The Wealth Company AMC.

While corrections or drawdowns are sharp in both mid-cap and small-cap segments, these are more frequent and often more pronounced in the latter.

According to data from FundsIndia, since January 2004, the BSE Sensex has spent 33% of trading days down by more than 10% from its peak. Comparatively, the Nifty Midcap 100 index has spent 48% of trading days below this threshold, while the Nifty Smallcap 100 index has lived 64% days in the same boat. However, the small-cap index has spent nearly 37% of its days down more than 30% from its peak, compared to just 10% by the mid-cap index.

That is not just a statistic. It is what shapes behaviour, influencing whether you remain invested or exit lock, stock and barrel. For many, assets that leave enough breathing room to persist amid uncertainty are the best investments.