Both mid- and small-cap funds continue to attract strong investor flows. Mid-cap funds received ₹5,085 crore of net inflows in September, while small-cap funds received net inflows of ₹4,362 crore, according to the Association of Mutual Funds in India (Amfi). However, the BSE 150 MidCap Index is flat while the BSE 250 SmallCap Index is down 2% in the one-year period.
In an interaction with Mint, Pankaj Tibrewal, a mutual fund industry veteran and founder and chief investment officer of investment management firm Ikigai Asset Manager, shares why he sees small-caps offering more investment opportunities than mid-caps at present, and why retail investors should avoid direct investing in mid- and small-cap segments. Edited excerpts:
There’s a lot of noise around mid- and small-cap valuations. Are you concerned about this space?
While I am overall positive on mid- and small-cap stocks, I am slightly more cautious about mid-caps than small-caps at the moment. The mid-cap universe is defined by just 150 stocks, and mid-cap fund managers are required to deploy their assets into this limited pool. This has led to overcrowding, driving valuations much higher. Mid-cap funds are also experiencing strong investor flows, which again need to be invested in mid-cap stocks. In simple terms, too much money is chasing too few stocks. Small-caps, on the other hand, offer a much wider universe, allowing fund managers more flexibility and less crowding risk.
But aren’t small-caps considered riskier?
That may have been the case before, but now the structure of the market has evolved. Today, many companies classified as “small-caps” by market definition are leaders in their niches and have strong balance sheets. The average debt levels of small-caps have fallen sharply over the last few years. Unlike in 2018-19, solvency risks have reduced significantly. So, while volatility may be there, the risk of deep crashes due to financial stress is lower than before.
Today, many companies classified as “small-caps” by market definition are leaders in their niches and have strong balance sheets.
What about valuations? Don’t small-caps appear expensive?
On the surface, yes, if you just look at the price-to-earnings (PE) ratio. But valuations must be seen in the context of growth. On a PEG (price-to-earnings/growth) basis, mid- and small-caps are not expensive because they are expected to deliver 18-20% earnings growth, which makes their PEG ratio around 1.3 to 1.4, considered reasonable. In comparison, large-caps might look cheaper on PE, but since their earnings are growing only 8-9%, their PEG shoots up to around 2, which actually makes them more expensive relative to growth. So, when you adjust for earnings growth, small- and mid-caps are better valued than large-caps.
Are you ruling out any sharp correction in small-caps?
There could be a time-correction (consolidation phase), rather than a major crash. The balance sheets are much stronger today, and capital is available for quality businesses. However, individual stock-level risks remain high. There are companies rallying purely on narratives without real cash flows. Investors need to look beyond profits and check whether companies are generating actual cash.
What’s your advice to retail investors looking at this segment now?
Stay invested through SIPs (systematic investment plans) rather than a lump sum. This segment won’t deliver returns in a straight line. There will be ups and downs. Investors should focus on fund managers who are experienced at managing risk in this space and have a process-driven approach. The next few years will be a stock-picker’s market, not a broad-based rally like we saw from 2020 to 2023.
The next few years will be a stock-picker’s market, not a broad-based rally like we saw from 2020 to 2023.
Should investors still allocate to mid- and small-caps?
Absolutely. Over the long term, many of India’s future large companies will emerge from these segments. Small- and mid-cap companies represent sunrise sectors that are driving earnings growth in the economy. Excluding them entirely could mean missing out on long-term wealth creation. But selectivity is key. However, retail investors should avoid investing in these stocks directly and conduct thorough due diligence to minimize risks.
Why should retail investors avoid investing directly in mid- and small-caps?
In this segment, it’s not enough to chase growth stories—you must ensure that the growth is real. Many companies show profits, but not necessarily generate actual cash, which is a major red flag. Governance risks are much higher in companies beyond the top 500, where about 85% are audited by nondescript auditors—auditing firms that don’t audit any major, reputable companies. In around half of these companies, promoters themselves sit on the audit committee, which compromises independence. These factors make forensic screening essential to eliminate companies with weak cash flows and governance issues, which retail investors may not be equipped to do themselves.