Indian Small-Caps Run Risk Of Extended Selloff As Earnings Slow

The tide is turning against India’s smaller companies as weak earnings and a souring economic outlook spur a downturn in their shares.

Key gauges of small- and mid-sized companies have tumbled since hitting September highs, putting them close to a so-called technical correction of a 10% peak-to-trough decline. The Nifty Midcap 100 Index is heading for its biggest monthly drop since the pandemic, tracking losses in the broader market, while the Nifty Smallcap 250 Index is set to fall the most in more than two years.

The meltdown in October, a sharp reversal from a searing rally in such stocks in the previous months, reflects wavering investor sentiment due to cooling earnings momentum. Despite the selloff, the stocks are still trading at high valuations, signaling investors may book profits and chase rallies in other markets such as China. 

“Many of high beta stocks in this segment were trading at frothy valuations and are typically the first to be dumped by investors as market sentiment weakens,” said Kranthi Bathini, a strategist with Mumbai-based WealthMills Securities Pvt. Bathini expects the selloff to extend due to lukewarm earnings and volatile geopolitical situation.

The losses follow tactical rotation by investors in favor of Chinese stocks that continue to trade at cheaper valuations despite a world-beating rally. The MSCI India Index is trading at a valuation of about 22 times its one-year forward earnings, nearly double the multiple for the MSCI China Index. It also coincides with the fading expectations of interest-rate cuts by the nation’s central bank as inflation remains sticky.  

Small-cap stocks have emerged as a barometer of animal spirits in India’s equity markets in the past year, backed by the choice to pick companies operating in niche and fast-growing segments of the economy. Mutual funds exclusively investing in such companies have been getting a bigger share of monthly flows coming into overall equity products. 

The small- and mid-cap stock funds received more than 30 billion rupees ($357 million) each in September, while flows into large-cap funds trailed at 17 billion rupees, according to Association of Mutual Funds in India data. 

“This segment does well in India during a period of good economic cycle and as long as that stays, they will perform,” said Taher Badshah, chief investment officer at Invesco Mutual Fund. Future gains will depend on how these companies demonstrate execution and delivery of their growth potential, he said.