Smallcap stocks have significantly outperformed largecaps since April 2023, with market value in the segment growing 2.3 times compared to 1.4 times for the largecap index. While this rally has pushed smallcap valuations to 32.5 times trailing earnings, Vikas Khemani, founder of Carnelian, argues that the headline valuation gap obscures a more favorable underlying growth profile for domestic-focused businesses.
Carnelian's analysis suggests that when comparing like-for-like domestic, non-financial companies, smallcaps are currently cheaper than their largecap counterparts. On FY27 estimates, smallcaps trade at approximately 30 times earnings, whereas domestic largecap franchises trade at a median of 42 times. This valuation discrepancy is often masked by the largecap index's heavy weighting toward financials, global commodities, and IT, which typically trade at lower multiples.
Beyond valuation, the earnings outlook remains a primary driver for the segment. Smallcap profits are projected to grow at a 22% annual rate between FY26 and FY28, outpacing the 16% growth expected for largecaps. Khemani notes that the smallcap universe contains a larger pool of high-growth businesses, with 279 smallcaps compounding profits at over 20% annually between FY16 and FY26, compared to only 13 largecaps.
Smallcaps provide purer exposure to India's domestic economy, with 59% of their profits derived from local factories, hospitals, retailers, and builders. In contrast, only 32% of largecap profits originate from these domestic, non-financial sectors. This distinction is critical as domestic businesses have significantly outperformed global-facing largecap revenue streams in recent years.
Khemani highlights that emerging Indian themes, such as electronics manufacturing, railway infrastructure, and specialized healthcare, are almost exclusively represented within the small and midcap universe. These sectors have demonstrated robust profit growth, with a median annual rate of 33% between FY20 and FY26.
Despite the growth potential, Carnelian cautions that the smallcap segment carries inherent risks, including lower liquidity, thinner free floats, and a tendency to experience sharper declines during market corrections. Khemani emphasizes that segment-level investing is less effective than rigorous company-level selection, focusing on durable competitive moats, strong governance, and capable management. The firm intends to formalize its focus on this segment with the upcoming launch of the Carnelian Small Cap Mutual Fund.
Small-cap companies may benefit from niche markets and faster expansion, but their share prices can be more vulnerable to low trading volumes, concentrated ownership and abrupt earnings changes. A fund manager's positive long-term view is an investment thesis, not evidence that the entire segment is attractively priced today. A defensible comparison should examine company balance sheets, governance, cash generation and valuations rather than rely on index declines alone. Investors who require funds in the near term may face losses if they must sell during an illiquid downturn. When quoting a named market expert, readers benefit from knowing the time horizon, assumptions and whether the speaker has exposure to companies being discussed.
