India's Smaller Firms Face Less Heat Than Frontline Peers Despite Deeper Woes

India's Rs 423 lakh-crore stock market is in the middle of one of the biggest correction in recent times. Yet, in an unforeseen way, stocks of small and mid-cap companies avoided a heavy selloff and fell in line with benchmark gauges.

Global funds have sold stocks worth over Rs 1.59 lakh crore—a record in terms of streak and magnitude since Sept. 27, while domestic institutions have bought stocks worth over Rs 1.5 lakh crore during the same period.

This has led the market to fall below the so-called correction zone, the first time since the plunge during Covid-19. During this rout, the broader market fell below the benchmark indices, with foreign investors not having sold heavily in small and mid-cap segments.

The Nifty corrected by 11.1% from the recent peak, while the mid-and small-cap indices corrected by over 11% and 10%, respectively.

This correction comes when these small and mid-caps were considered overvalued, with these companies receiving more earnings downgrades than the frontline stocks.

Smaller firms were anticipated to fall more than benchmarks due to their typically higher valuations and susceptibility to earnings downgrades, said Ajit Mishra, senior vice president of research at Religare Broking Ltd. The in-line fall suggests that the selloff was more broad-based, driven by macroeconomic concerns or global cues, he said.

The 'cautious optimism' about India's long-term growth prospects might have kept investors from excessive panic-selling in small caps, Mishra said.

During the market peak in late September, the one-year forward price to earnings of NSE Nifty 50 was 23.8 times, while that of the mid-and small-cap index was at 43 and 30 times. Currently, the forward P/E of Nifty stands at 22 times, while the mid-and small-caps fell to 36 times and 29 times, respectively.

Mid and small caps recorded a higher proportion of misses, while large caps had an equal number of beats and misses in Elara Capital's coverage of companies. Its coverage universe saw an overall decline in its beat-to-miss ratio. Earnings downgrades were more for small and mid-cap stocks than for the blue-chip ones in JM Financial Securities coverage.

However, experts are of the view that small caps might not fall further as valuations appear reasonable. Valuations are in line with "decent earnings delivered and expected earnings growth to be strong" in the future, said Feroze Azeez, deputy chief executive officer of Anand Rathi Wealth Ltd.

The expectation for profitability for next year is in the range of 11-20%, indicating that healthy profit growth is likely to continue this year, especially for small and mid-caps, Azeez said.

Sustained domestic flows into these smaller companies also helped them avoid a crash, experts said.

Small and mid-cap stocks managed to avoid a steep decline due to sustained retail investor interest and selective buying by domestic investors, Mishra said. "Some small and mid-caps have strong earnings visibility and growth potential, limiting indiscriminate selling."

A report by ICICI Securities shows that foreign investors' selling supply was moderate in the small and mid-cap space, compared to selling seen in top companies. However, the official data regarding FII ownership and selling segment-wise is now known yet.

If FPIs had aggressively sold mid-small caps, the drawdowns in these indices would have been large, given their lower liquidity, analysts at ICICI Securities said in a report. "Nevertheless, large drawdowns during this selling period were witnessed in consumption and unsecured lending space across large, mid and small-cap spaces."

FPIs’ relative leaning towards mid and small caps reflects higher growth outlook and under-ownership, the note said.

The recent changes to mutual fund trading could also explain why small and midcap companies have not corrected as much as expected.

First, the liquidity stress test requires the liquidation of large liquid stocks before small and mid-cap stocks, leading to lesser liquidity. Further, the volume-weighted average price criteria to buy and sell shares by mutual funds ensured that there was no dumping of shares by domestic funds, as buying and selling of shares needs to take place near the VWAP price.

India's stock gauge also began receiving target cuts, given the earnings and slowdown risks. HSBC Global Research has cut the 2025 year-end target of BSE Sensex as risks of earnings downgrades amid high valuations weigh on the global brokerage.

The market's trajectory from now will depend on key factors such as increased government capital expenditure and a revival in private sector investment, Mishra said. The Reserve Bank of India's monetary policy decisions will be crucial in shaping investor confidence, he added. "Investors should remain cautious while seeking opportunities in resilient, high-quality stocks."

The FII trend suggests that the selling pressure is on a downward trend and we expect that the Indian market being attractive will start selling inflows soon, according to Azeez.