Mid and small-cap stocks at 20-year high premium to large caps: Why investors may need to shift fresh money to large caps

For the past few years, small and mid caps have dominated equity performance charts. Real wealth generation has been concentrated in these pockets, even as frontline names have disappointed. Over the past three years, the BSE 150 Midcap and BSE 250 Smallcap indices have jumped 12.2% and 10.9% (annualised), respectively, and the BSE100 index by 5.7%. Even amid a prolonged market correction, the broader market has exhibited better resilience. Since the correction began on 26 September 2024 (the BSE 500 Index’s all-time high), mid- and small-cap indices have shed only 3.3% each, while the large-cap index has lost 6.8%.

Investors seem to have written off the big boys. Many continue to merrily pile into small- and mid-cap funds even as market conditions turn sour. According to data from the Association of Mutual Funds in India, this September saw inflows of `16,874 crore into small- and mid-cap funds—the highest ever. Meanwhile, large-cap funds saw modest inflows of Rs.859 crore. Clearly, investors don’t have faith in large caps.

Investor participation increasingly concentrated in small & mid caps


Small- and mid-cap funds now account for over 50% of total active equity inflows.

Poles apart

The divergence has now reached acute proportions. A report by DSP Mutual Fund finds that small and mid caps now trade at their highest relative price levels versus large caps in over two decades. “Small- and mid-cap indices are roughly 72% and 56% above their historical relative-price medians versus the Sensex, both close to three standard deviations above long-term averages,” observes Sahil Kapoor, Executive Director–Market Strategist and Head of Products, DSP MF.

In the backdrop of a broader market correction, the differing paths are particularly glaring. Mid- and small-cap stocks trade at full-blown bull-market multiples, while several large caps trade near decade lows, the DSP report observes.

“Normally, investors pay a premium for the stability of large companies. Today, the premium sits with the smaller ones,” remarks Niharika Tripathi, Head of Products and Research, Wealthy.in.

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The sharp outperformance in small and mid caps needs to be put into context. For much of the post-pandemic period, Indian equities rode domestic growth drivers, including higher government capital expenditure, a manufacturing revival, economic formalisation and rising private investment. These fuelled optimism around businesses linked to themes such as capital goods, defence, healthcare, capital markets, industrials and consumption.

“Given that many of these themes were more heavily represented within the mid- and small-cap universe, a significant share of the value creation accrued to this segment. Robust earnings growth, coupled with sharp valuation re-rating, resulted in an extended period of outperformance,” notes an Axis Mutual Fund report. Large caps, on the other hand, bore the brunt of massive selling by foreign institutional investors. This was compounded by company-specific challenges at some of the Nifty heavyweights.

Putting the lens on earnings

Much of the narratives favouring small and mid caps have centred on superior earnings growth relative to large caps.

However, if you dig deeper, the earnings story is very selective. 3P Investment Managers, an asset management company led by veteran fund manager Prashant Jain, analysed returns from 1 May 2022 to 30 September 2026, beginning when small and mid caps started outperforming large caps. During this period, the Nifty MidSmallcap 400 index returned 99%, versus 35% for the Nifty 100 index (large-cap index). The surprising part was that the bulk of the excess returns were driven by the top 4% of mid- and small-cap stocks (16 stocks) with returns above 1,000%. Beyond these outliers, return distributions were largely similar.

“It is evident that specific themes/few companies with outsized returns have driven higher returns for the mid- and small-cap index. It would therefore be erroneous to conclude that mid and small caps as a category outperform or have outperformed,” notes 3P Investment Managers in its investor factsheet.

The report says the profit and market capitalisation share of large caps and mid and small caps from 2015-16 to 2025-26 tells a similar story. Excluding metals as well as oil and gas, mid and small caps’ market cap share rose from 25% in 2020-21 to 34% in 2025-26, while their share of aggregate profits remained broadly unchanged. This analysis suggests that the outperformance of the mid- and small-cap index is cyclical and should revert over time, according to the same report.

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Meanwhile, after several quarters of muted growth, Nifty 50 profits are expected to grow 22-23% year-on-year in the September quarter, the strongest in 17 quarters, according to estimates by Motilal Oswal Mutual Fund. Small caps may still post high growth on paper. The same estimates see profits of small caps growing about 29% this quarter, against 11% for mid caps.

“But two things matter more than the headline number,” suggests Tripathi. “First, growth in smaller companies is far more uneven: a handful of strong performers can lift the average while many others disappoint. Second, a lot of that growth is already reflected in their prices.”

Finding margin of safety

The starting point is where the risk becomes apparent. As per the DSP MF report, large cap stocks in India now trade at the 10th percentile of their five-year rolling compound annual growth rate (CAGR). In other words, large-cap returns sit near the bottom 10% of their historical return distribution. Barring the COVID decline, large caps haven’t been this attractive in over a decade.

“The current five-year CAGR of the Nifty 100 is only 7.6%, in the bottom 12% of its historical distribution. Mid caps are at 15.4% and small caps at 15.0%, much closer to their normal base rates. Historically, low trailing returns have generally been associated with better subsequent return odds, while extraordinary trailing returns have reduced them,” observes Kapoor.

According to Elara Securities, the Nifty trades at 17.1 times one-year forward price to-earnings and 9% below its 10-year rolling average of 18.9 times. The Nifty Midcap 100 trades at 23 times, about 5% below its 10-year average, after a meaningful de-rating from its peak. The Nifty Smallcap 100 remains expensive at 23.8 times, around 34% above its 10-year average, leaving little valuation cushion if earnings disappoint.

If promised earnings fall short, the mid- and small-cap outperformance will start eroding fast. According to Kotak Institutional Equities’ analysis of the top decile of mid- and small-cap performers, outperformance was driven primarily by earnings upgrades, coupled with meaningful re-rating. As such, this cohort’s contin ued outperformance will depend on actual delivery versus the sharp increase in earnings expectations.

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However, large caps, free from the baggage of expectations, can surprise the market. Tripathi maintains, “Large caps today offer improving earnings at reasonable valuations. Small and mid caps need to deliver strong growth just to justify where they trade. If earnings fall short, that is where the disappointment will be sharper.”

Large caps today require much less to go right, asserts Kapoor. “Mid and small caps still need strong earnings growth to justify elevated valuations. Several large caps merely need expectations to normalise. That is a considerably better asymmetry.”

If large caps deliver mid-teens earnings growth over the next couple of quarters, they could see a recovery in sentiment, a valuation re-rating, and renewed investor flows, Rishabh Nahar, Partner and Fund Manager at Qode Advisors, points out.

Beyond valuations: macro risks

Relative valuations provide only one side of the story. Against the backdrop of a rapidly shifting macro environment, the risk-reward picture looks much sharper. In recent months, global conditions have become more uncertain. Global markets now face multiple, overlapping headwinds, including regional conflicts, elevated energy prices, supply shocks, rising inflation, higher bond yields, and the onset of a global rate-hike cycle.

These shifts have increased the importance of earnings resilience and valuation discipline. In such an environment, it is vital to look beyond growth themes and rich valuations, as the market is no longer in the early stage of the cycle, suggests a note by Axis MF. “This is where large caps deserve a fresh look. Not only do they remain integral to India’s long-term growth story, but many now offer an attractive combination of earnings visibility, financial strength and more reasonable valuations after a prolonged period of relative underperformance,” the fund house reiterates.

Tripathi asserts, “The macro backdrop now adds to the case for large caps. The Reserve Bank of India has just raised rates, crude is elevated, the rupee is under pressure, and foreign investors remain sellers. In such phases, companies with strong balance sheets, pricing power and access to capital tend to hold up better. Smaller companies are usually more exposed to higher borrowing costs and slowing demand.

Small & mid caps grow market cap share, not profit pool

Better the past, poorer the future returns

Large caps currently sit near the bottom decile of past return, which suggests improved forward return.

Starting 5Y return decile and subsequent 5Y CAGR

Temper the hopes

For mid- and small-cap investors, the time may have come to calibrate expectations. According to DSP MF, over the last year alone, small and mid caps have outperformed the Sensex by 21.5% and 14.1%, respectively, while the top 10 stocks by market cap have underperformed the Nifty 500 by about 10.6%. History does not say this divergence must reverse immediately. But the previous mid and small cap relative peaks in 2007, 2010 and 2017 were followed by meaningful relative mean reversion.

Kapoor cautions, “The opportunity in mid and small caps tends to be greatest when their excess return over large caps has disappeared. Today, we are at almost the opposite extreme.” He further points out that across cycles, mid and small caps tend to build substantial alpha (i.e. outperformance) during bull markets and subsequently surrender a significant part of that relative alpha during downcycles.

The Axis MF report also indicates that, historically, sustained outperformance by any market cap segment has eventually moderated as valuations and earnings expectations adjusted. “Importantly, the starting point matters for better risk-adjusted returns. When valuations fully reflect growth expectations, future returns tend to rely more on earnings delivery.”

Small & mid caps still rule the charts

Small and mid caps retain outperformance even amid recent market correction.

Rebalance, don’t replace

Given the market scenario, Axis MF insists it is imperative to maintain balance rather than take an aggressive market cap position. The next phase of Indian equities may not be about large caps versus mid and small caps. It may be about recognising that the op portunity set now includes large caps as well.

According to Nahar, cheaper does not automatically mean better. “Our approach is to follow the opportunity, not the market cap label. We would increase exposure to large caps when the combination of growth, valuation and prospective returns justifies it—not simply because they have underperformed. The goal is not to own what has become cheap; it is to own what offers the best combination of growth and value going forward.”

This should be a rebalancing decision, not a market call, says Tripathi. “Investors should compare their current split with their target allocation. If small and mid caps have drifted well above it, bringing them back in line makes sense. A large-cap core portfolio, typically through a selection of large-cap, flexi-cap or index funds, should anchor most portfolios.”

That doesn’t mean you should sell your existing small and mid-cap funds altogether, she adds. For investors with a horizon of seven years or more and the ability to handle sharp swings, these segments still have a role. The goal is to hold them in a measured pro portion, not to time an exit.

Kapoor reckons existing long-term mid- and small-cap allocations that remain within the intended asset allocation do not need to be disturbed. “Excess mid- and small-cap exposure created by outperformance should be rebalanced. And fresh equity money can be tilted meaningfully towards large-cap, flexi-cap or large-cap biased strategies where the manager has the ability to exploit the valuation dispersion,” he adds.

The simplest way to rebalance is to redirect fresh money, Tripathi maintains. Pointing new systematic investment plans or lump sums towards large-cap or flexi-cap funds shifts the mix gradually and avoids the exit loads and capital gains tax that come with redeeming existing units.