India’s small-caps to face another tough year on earnings-valuations mismatch

The underperformance of India’s small-cap firms relative to large- and mid-caps this year, after two years of strong gains, is likely to persist into 2026 as stretched valuations, moderate earnings and thin liquidity continue to weigh, analysts said.

India groups listed firms by market value, with companies

ranking below 251 classified as small-caps. The market rebound through 2025 has remained narrow, leaving smaller companies unable to participate meaningfully.

The Nifty small-cap index has fallen 9% in 2025, its first lag behind the Nifty 50 and Nifty mid-cap in three years, even as the two benchmarks touched record highs in November after 14 months on stronger earnings, policy support and firm domestic inflows.

The headline gains conceal deeper market strain. Nearly 73% of Nifty 500 stocks remain more than 10% below their record highs.

Small-caps, particularly, have struggled to recover after confirming a bear market earlier this year. The index is 13% below the record highs hit in 2024, and nearly half the stocks in the index are still trading more than 50% below their all-time highs.

A broad-based recovery is distant, analysts say, largely because valuations are still elevated. While the Nifty 50 trades near its 10-year average price-to-earnings (P/E), mid-caps and small-caps command 12-month forward P/E multiples of 29.2x and 25.1x — well above the long-term averages of 23.1x and 16.7x.

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“Either valuations must correct further, meaning more pain for small-caps, or earnings in the second half must rebound so sharply that they start outperforming mid- and large-caps. Neither looks likely,” said Harsha Upadhyaya, chief investment officer at Kotak Mahindra Asset Management Company.

The weakness has hit retail investors the hardest. They account for about 35% of the NSE cash market activity and own 8.6% of NSE-listed companies, with high exposure to small- and mid-caps.

“Volatility and illiquidity premia in small-caps are hugely underpriced right now,” said Dhananjay Sinha, chief executive and co-head of institutional equities at Systematix Corporate Services.

Illiquidity premia refers to the extra return investors expect from small-cap stocks as they trade at lower volumes and have fewer buyers compared to large-caps.

Several fund houses have already halted or restricted inflows into small- and mid-cap schemes, a cautionary signal, even as retail investors continue chasing higher returns, Sinha said.

Valuations had become “priced for perfection” after strong gains in 2023 and 2024, when the small-cap index surged 93%.

“When quarterly results in small-caps don’t match those valuations, the market is punishing them,” said Rishabh Nahar, partner and fund manager at Qode Advisors.

A risk-off global environment and a busy initial public offering pipeline have further diverted liquidity toward safer large-caps, Nahar added.