As volatility reshapes the broader market narrative, the small-cap segment has once again come into focus, particularly after a sharp correction that has reset both valuations and expectations. While the space had seen significant exuberance in 2023–24, recent developments, including geopolitical tensions and market-wide recalibration, have brought back a degree of balance.
In an interaction with BW Businessworld, Chandraprakash Padiyar, Senior Fund Manager at Tata Asset Management, shares his perspective on the evolving small-cap landscape. He highlights the emergence of selective opportunities, the importance of bottom-up stock picking, and why future returns are likely to be driven more by company fundamentals than broad-based rerating.
Edited excerpts:
Do you believe the recent correction in small caps has created selective opportunities where earnings growth could surprise on the upside?
During 2023–24, market expectations for earnings growth had run ahead of fundamentals, and valuations had expanded significantly. This led us to adopt a cautious stance at that time, including restricting lump sum inflows. However, the subsequent correction, combined with increased volatility and evolving geopolitical conditions, has led to a meaningful reset in both valuations and earnings expectations. In several cases, stock prices have corrected more than what the underlying fundamentals would suggest.
As a result, we are now seeing pockets within the small-cap universe where valuations are more reasonable and aligned with long-term growth potential. This creates a favourable setup where, if the external environment stabilises, earnings delivery for select companies could be better than current expectations. Such a scenario could lead to earnings upgrades and improved risk-reward for investors. That said, the opportunity is clearly selective and not uniform across the segment, reinforcing the need for a disciplined bottom-up investment approach.
Small-cap funds have outperformed large caps recently. Is this a sustainable trend or a short-term catch-up rally?
Short-term movements on either side for any market capitalisation should not be assumed as a linear trend. The small-cap segment of the market did not perform very well in 2025 relative to the large-cap segment and recent times are probably just a catch-up of some of that underperformance.
However, we do believe that earnings growth for select small-cap companies has room to grow faster for the foreseeable future, with valuations on the reasonable side, keeping us optimistic. We are hopeful of an early resolution of the West Asia conflict, which can drive better performance for the segment over the medium to long term.
Are small caps relatively immune to FII selling?
In the long term, we believe flows are the least important variable to track for stock prices. Fundamental performance relies on earnings growth, cash flow growth and sustainability. In the short-term, stock prices do get impacted by flows which, in our scheme of things, do not have as much importance and hence we do not track flows actively.
Valuations in the small-cap space remain elevated. Are we in a frothy zone, or is earnings growth justifying it?
Valuations in the small-cap segment were elevated during the 2023–24 period, which was one of the key reasons behind our cautious stance. At that time, earnings expectations were high and valuations did not adequately compensate for the risks involved.
However, the recent correction has led to a recalibration in valuations across the segment. In many pockets, valuation premiums have moderated, and we are now seeing more reasonable entry points for investors. At the same time, earnings expectations have also come down, creating a more balanced risk-reward environment.
It is important to note that the small-cap space is not homogeneous. While certain pockets may still appear expensive, there are segments where valuations are now justified by growth potential. In such cases, if companies deliver better-than-expected earnings, current valuations can be supported and may offer upside.
Overall, we would not characterise the entire segment as frothy at this stage. Instead, we see a more nuanced landscape with selective opportunities, making stock selection critical.
How do you see earnings growth shaping up for small-cap companies over the next 12 months?
We expect earnings growth in the small-cap segment to improve over the next 12 months. The recent moderation in earnings expectations, following the correction in stock prices, has created a more realistic base for growth.
However, it is important to view this in the context of the strong earnings expansion witnessed between FY21 and FY25. Given this high base, sustaining very high growth rates across the board may be challenging. As a result, incremental growth is likely to be more company-specific rather than broad-based.
We believe that the sustainability of earnings, supported by cash flows and reasonable valuations, will be more important than short-term growth spikes. Investors should therefore focus on businesses that demonstrate consistent execution and the ability to compound earnings over time.
Do you expect the segment to witness a broad-based recovery, or will performance remain largely stock-specific going forward?
In the near term, there is a case for a broader recovery in the small-cap segment as valuations have corrected and earnings expectations have become more realistic. This could lead to a general upmove across the segment over the next 12 months.
However, over a longer horizon of 3 to 5 years, we expect performance to be increasingly stock-specific. The phase of broad-based rerating appears to be behind us, and future returns are likely to be driven by company-level fundamentals.
Our investment approach is centred on bottom-up stock selection. We focus on identifying businesses with strong earnings visibility, reasonable valuations, and the ability to generate sustainable cash flows. We also prefer a relatively concentrated portfolio of high-conviction ideas to optimise risk-reward over time.
If markets correct again, where do you see the biggest risk within small caps today?
We believe volatility will remain a defining feature of the market environment going forward. Investors should be prepared for continued fluctuations rather than expecting a linear recovery. Key risks include prolonged geopolitical tensions, particularly those impacting energy markets and global trade. Elevated crude prices, supply chain disruptions, and any slowdown in global GDP growth could have a cascading impact on corporate earnings and market sentiment.
Additionally, factors such as high fiscal spending, rising leverage in developed economies, increasing use of industrial policy, and evolving trade dynamics, including capital controls, can contribute to uncertainty.
Given these dynamics, the primary risk lies in the interplay between macroeconomic and geopolitical factors, which can influence both earnings and valuations. Investors should therefore adopt a long-term approach and focus on fundamentally strong businesses that can navigate such environments effectively. |
