Why smallcap funds are still a buy: A long-term strategy from Aditya Khemani

Edited excerpts from a chat:

How do you assess the current market cycle in India, especially in the context of the Iran war, subdued performance in the last 2 years and earnings expectations?
Indian equity markets have delivered strong returns over the last couple of decades. However, a closer look at this performance shows that it has consisted of phases of strong returns interspersed with periods of negative returns.After a robust run between 2020 and 2024, the last 24 months have been characterised by a slight slowdown in India’s economic growth, leading to earnings downgrades for corporate India on the back of strong earnings expectations.

Live Events

As a result, equity markets have remained weak, which can be described as a consolidation phase after a very strong rally. Over the last six months, there were signs of a gradual economic uptick, supported by government measures such as GST rate cuts, among others. Consequently, corporate earnings performance in the December quarter after nearly five to six quarters of disappointment came broadly in line with expectations.

Hence it looked like equity markets could start to do well after a period of consolidation. However, the onset of the Iran war has postponed these expectations, impacting short-term projections. As things stand, earnings performance for the March quarter, and especially the upcoming June quarter, is likely to remain weak. Any improvement thereafter will depend on how quickly the West Asia crisis is resolved and whether commodity prices, particularly crude oil, ease.

That said, markets are typically forward-looking and tend to anticipate earnings recovery much in advance. Therefore, equity markets could start to improve as soon as there is positive news flow around the resolution of the crisis, even if earnings remain weak over the next few quarters.

Overall, a significant portion of the negatives appears to have already been priced in by the market. For long-term investors, this presents a good opportunity to take advantage of the weakness seen over the past couple of years.

Corporate earnings have remained relatively strong. Do you see this momentum sustaining, or are margins at risk going forward due to headwinds relating to crude oil, raw material prices, expectations of interest rate hikes and rupee depreciation?

Earnings in the short term will depend significantly on how the situation in West Asia evolves. The longer the crisis continues, the more prolonged its impact on earnings is likely to be. Beyond crude oil, supply chains across several industries have been disrupted, affecting both availability and cost of inputs. The issue is not only supply constraints but also the sharp volatility in prices.

Additionally, it may not be feasible for many industries to immediately pass on these higher costs to consumers. As a result, the near-term outlook on corporate earnings remains quite uncertain. However, history suggests such as during the Russia–Ukraine war that earnings tend to recover once geopolitical tensions ease. As mentioned earlier, equity markets are always forward-looking, and the moment there are clear signs of resolution, markets are likely to quickly price in an earnings recovery.

When it comes to small and midcaps, how comfortable are you with regard to valuations? Is the risk-reward favourable now?
Based on historical valuations, the small and mid-cap space appears optically more expensive compared with its levels over the past 10 years. However, a closer analysis of the SMID segment reveals a meaningful improvement in fundamentals, which justifies this re-rating.

The risk premium that investors assign to these companies depends on several factors, including balance sheet leverage, the conversion of profits into operating cash flows, corporate governance standards, and overall financial discipline. Across these metrics, the SMID space has shown significant improvement compared to where it stood a decade ago.

As a result, investors are now willing to assign a lower risk premium to this segment than in the past, which explains why valuations appear higher on the surface. Moreover, many of these companies are no longer truly “small” in terms of market capitalisation or profit contribution. Consequently, their earnings resilience has improved, and they are less cyclical than they were earlier. Taking all these factors into account, while valuations may not look cheap optically, there are strong structural reasons behind them.

Over the long term, the SMID space is expected to deliver mid-teens earnings growth. Therefore, it remains an attractive segment for investment and should form a part of a well-diversified portfolio allocation.

If one has a long-term view of 5 years, how bullish should one be on smallcap funds?
As discussed earlier, the last couple of years have been a consolidation phase for the SMID space. During this period, a large part of the froth has corrected, and earnings expectations have moved closer to reality. As a result, the segment appears well positioned from a long-term perspective. While it is difficult to forecast future returns with precision, in my view, the long-term outlook is unlikely to be very different from the past.

Over the last 10 years, the small-cap funds benchmark the BSE 250 SmallCap Total Return Index (TRI) has delivered a CAGR of around 15.5%, and well-performing active funds have generated returns higher than this. Therefore, from a long-term standpoint, the small-cap segment remains attractive. However, investors should have a minimum investment horizon of five to seven years when allocating to the small-cap category.

Which sectors are likely to lead the next earnings cycle in your view?
If I had to choose one large sector, I believe financials will lead the market, driven by strong earnings performance supported by reasonable valuations. That said, the market today also offers several attractive mini-themes. Some themes that look particularly promising from an earnings growth perspective include electronic manufacturing services, quick commerce, contract manufacturing in pharmaceuticals, financialisation, hospital sector, private banks, and renewables.

Which sectors or themes are you currently overweight on, and what is the underlying investment thesis?
At a broader sector level, we are overweight in financials, consumer discretionary, and healthcare, and these three sectors form a significant portion of our portfolios. Within each of these broad sectors, we are positive on specific sub-themes. Within healthcare, we are overweight on the services side, with significant exposure to hospitals and contract development and manufacturing companies. In consumer discretionary, we are positive on themes such as quick commerce, aviation, and retail. Within financials, we are overweight across both lending entities such as banks and NBFCs as well as non-lending segments, including capital markets intermediaries, insurance companies, and related themes.

In addition, we are overweight on the real estate sector. Each of these sectors and themes is supported by distinct structural drivers. For instance, within hospitals, we are seeing strong growth driven by two key factors. First, there is value migration from smaller hospitals to large, best-in-class tertiary care hospitals.

Secondly, rising health insurance penetration is leading to a shift in consumer behaviour, with patients increasingly opting for high-quality tertiary hospitals. Within the capital market theme, our positive view is based on the fact that only a single-digit percentage of household wealth in India is currently invested in equities, compared with around 40–50% in developed markets.

This suggests a long runway for growth, and capital market intermediaries are likely to continue performing well over the foreseeable future. The CDMO segment also looks attractive, supported by the “China plus one” and “Europe plus one” strategies, which are benefiting Indian CDMO players. These companies are gradually moving up the value chain and strengthening their position within the global innovator pharma supply chain.

Electronic manufacturing remains a strong theme due to the government’s emphasis on Atmanirbhar Bharat, with the electronics industry steadily transitioning from import dependence to indigenous production. Finally, quick commerce continues to look promising, driven by a sustained shift in consumer behaviour toward convenience-led consumption models.

Are there any contrarian bets you are taking that the market may be underappreciating?
One of the sectors where we have continued to increase our exposure is real estate. Within this space, we are particularly positive on companies that have a healthy mix of residential real estate and annuity-based commercial portfolios. In the real estate industry, we are witnessing a strong value migration from smaller builders to large, established developers.

Owing to their strong brands, these large developers are able to, first, tie up with landowners on favourable terms with relatively low upfront capital outlays, and secondly, they are able to sell quickly on their brand trust. As a result, large developers are well positioned in an industry with a sizeable profit pool. Additionally, these companies are increasingly using their cash flows to build substantial commercial annuity portfolios, which provide steady and predictable cash flows.

Given the way the market has penalised the sector, we see attractive value in some of these companies at current levels. Alongside this, we are also taking a contrarian stance in select sectors that have seen short-term pressure due to factors such as high commodity prices and demand destruction. Some of these sectors include aviation and cement.