India’s stock market in the first half of calendar year 2025 (H1CY25) painted a tale of divergence between large-cap strength and small-cap weakness. While benchmark indices like the Sensex and Nifty posted strong gains of around 8 percent, the same could not be said for their smaller counterparts. The BSE Midcap index remained largely flat with a marginal 0.2 percent gain, and the BSE Smallcap index fell 1.7 percent, reflecting growing investor caution amid global uncertainties and valuation concerns. With the onset of H2CY25, the key question for investors is whether this subdued segment is poised for a turnaround or if further volatility lies ahead.
What Went Wrong for Smallcaps in H1 2025
The underperformance of mid- and small-cap stocks in the first half of the year was not entirely unexpected. Several factors weighed on investor sentiment. A major trigger was the heightened global risk-off mood driven by geopolitical tensions, including reciprocal tariffs and supply chain uncertainties. Foreign institutional investors (FIIs), typically wary of risk in times of global uncertainty, significantly reduced their exposure to Indian small- and mid-cap stocks. This shift was reinforced by weak corporate earnings in Q3FY25, especially from smaller companies that failed to meet expectations, resulting in further downgrades.
Adding to this pressure was muted credit growth in large corporate and consumer durable loan segments, which disproportionately impacted smaller companies more reliant on external financing. The result was a sharp pullback in riskier assets. The Nifty Smallcap 100 index, for instance, was down nearly 14 percent by mid-April, while the Nifty Midcap 100 had slipped by around 9 percent. In contrast, largecaps held relatively steady, with the Nifty 50 staying mostly flat during the same period, offering a safer haven for investors.
Signs of Recovery in Late Q2
Despite the poor showing in the early months, there were signs of a rebound toward the end of H1CY25. According to data from Ionic Wealth, the BSE Smallcap index staged a significant comeback, rising more than 20 percent in the second quarter alone. This resurgence was driven by improving corporate earnings, particularly in Q4FY25, as well as renewed interest from domestic institutional investors and retail participants who viewed the correction as a buying opportunity.
Iconic Wealth noted that many small-cap names, after enduring steep losses, had entered oversold territory by April. This created fertile ground for a technical and sentiment-driven bounce. The market breadth also showed signs of improvement, as previously underperforming stocks found buyers on the back of stabilising macro conditions and promising corporate updates.
Tailwinds Lining Up for H2
Several macroeconomic tailwinds are now aligning in favour of a potential smallcap resurgence. The Reserve Bank of India’s dovish policy stance, easing inflation, and recent moderation in oil prices are collectively creating a supportive backdrop. Moreover, FIIs, who were net sellers during early 2025, have begun returning to Indian equities, providing a much-needed sentiment boost.
Adding to this optimism are sector-specific fundamentals. Bajaj Finserv Asset Management, in its recent study, highlighted that while the small-cap index has delivered only 4 percent returns since FY24, profit after tax (PAT) has surged by 38 percent, indicating strong underlying performance that has not yet been fully priced in. Furthermore, 74 percent of the top 250 small-cap companies have reported double-digit returns on capital employed (ROCE), suggesting that a large portion of the segment remains fundamentally strong.
Analysts at Ionic Wealth also pointed to the historical correlation between profit growth and equity market rallies. In years like FY21, FY22, and FY24—periods of robust PAT expansion—equity indices delivered double-digit returns. This pattern supports the argument that the current earnings revival in smallcaps could drive the next leg of the market rally.
Valuations Remain a Concern
Even with these positives, caution continues to prevail among analysts. One of the biggest red flags remains valuations. Forward price-to-earnings (P/E) ratios for small- and mid-cap indices stand at 35.8x and 24.5x respectively—well above historical averages. Analysts worry that such elevated multiples could limit further upside, especially if earnings momentum does not hold up.
VK Vijayakumar, Chief Investment Strategist at Geojit Investments, noted that while quarterly earnings have improved, investors must remain selective. “Despite that, quality mid and smallcaps have the potential to outperform,” he said, but added that valuations need to be taken into account when chasing returns in this space.
Ionic Wealth echoed this sentiment, highlighting that while liquidity flows and earnings have improved, a broad-based rally across all smallcaps remains unlikely. Instead, stock-specific strategies, driven by earnings visibility and strong fundamentals, are likely to perform better.
Investor Flows Show Confidence
Interestingly, investor flows into small-cap funds have remained strong despite the segment’s recent underperformance on the bourses. According to data from the Association of Mutual Funds in India (AMFI), smallcap schemes received ₹3,214 crore in May 2025—higher than midcap and largecap schemes. This suggests that investors, particularly retail and SIP-based participants, continue to bet on the long-term growth potential of smallcaps.
Between January and May 2025, smallcap schemes accounted for over 15 percent of total equity fund inflows, reinforcing the idea that investor interest in this segment remains intact, even during periods of underwhelming short-term returns.
Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of Mint. We advise investors to check with certified experts before making any investment decisions.
