The Nifty Smallcap 250 delivered a stunning 45% return in 2025, significantly outperforming large caps. But with valuations now at historical highs, is it time for caution? Our analysis suggests selectivity is key.
Valuation Snapshot
- Nifty Smallcap 250 P/E: 28x (10-year average: 22x)
- Premium to Nifty 50: 15% (historical average: discount of 10%)
- 40% of small caps trading above 30x P/E
- Earnings growth expectations: 18-20% CAGR
What's Driving the Rally?
Several factors have contributed to the small cap outperformance: massive retail participation through SIPs, limited FII selling in this segment, strong earnings momentum, and the "India growth story" narrative. These factors remain supportive but are largely priced in.
Risks to Watch
Small caps are more vulnerable to liquidity crunches and earnings disappointments. With valuations stretched, any negative surprise can lead to sharp corrections. The 2018 small cap crash—when the index fell 40% in 9 months—is a reminder of the risks.
Where to Find Value
- Capital goods and infrastructure: Order book visibility provides comfort
- Specialty chemicals: Correction has made valuations reasonable
- Regional banks: Trading at 1.0-1.2x book with improving ROAs
- Auto ancillaries: EV transition beneficiaries at reasonable valuations
Our Recommendation
We advise a cautious approach to small caps. Avoid chasing momentum in expensive names. Focus on companies with strong cash flows, reasonable valuations, and clear earnings visibility. Consider booking profits in stocks that have run up 100%+ without fundamental improvements.