Smallcap mutual funds attract 44% of equity inflows despite stretched valuations. Should investors be cautious?

Investor appetite for small and mid-cap stocks remains strong even as valuations in these segments continue to look expensive relative to large caps, raising questions about whether domestic flows are moving ahead of fundamentals.

The small and mid-cap funds attracted Rs 16,873 crore in September, accounting for 44% of the Rs 38,307 crore in net inflows into equity funds during the month. Overall equity fund inflows rose 31%, even as equity fund assets declined, according to a report released from Sharing a potential story angle from W by Groww.

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The report highlights a disconnect between where investors are putting their money and where valuations appear relatively attractive. Small-cap and mid-cap stocks continue to command a substantial premium over large caps, despite the market correction over the past year.

The Smallcap 250 index's forward price-to-earnings multiple declined from 25 times in September 2024 to 23.6 times in September 2026, a reduction of just 6%. Over the same period, the Nifty 50's forward multiple fell from 24.8 times to 17.6 times, a decline of 29%, according to the report.

The report said that the small caps were also trading at a 34% premium to large caps, compared with a historical average discount of 11%. Mid caps commanded a 47% premium, against a 19% historical average premium.

These comparisons suggest that the correction has not fully addressed the valuation gap between smaller companies and their larger peers.

The report also points to historical episodes that warrant attention. Following market peaks in 2007, 2010 and 2017, small caps underperformed large caps by a median of 30% over the subsequent two years. While historical patterns do not determine future returns, they illustrate the potential risks of entering a segment when valuations are elevated.

The continued inflows into small and mid-cap funds are particularly notable because large-cap funds, which were trading further below their own historical valuation levels, recorded outflows in August, the report notes.

The report favours large caps as the core of an equity portfolio, while recommending a more selective approach to mid and small caps. It also favours active management over passive exposure in these segments.

For investors, the key question is not simply whether small caps have corrected, but whether the correction has made them attractive relative to their earnings prospects. A fall in stock prices does not necessarily translate into compelling valuations if earnings expectations or underlying fundamentals do not support the prevailing multiples.

The divergence between fund flows and relative valuations is therefore worth watching. If investor allocations remain concentrated in the more expensive segments, the market could become increasingly sensitive to earnings disappointments or a change in risk appetite.

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The report's findings underline the importance of assessing valuations alongside fund flows, rather than treating strong inflows as evidence that a segment offers better investment opportunities.

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

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