Vikas Khemani of Carnelian Capital argues that small-cap stocks provide better domestic growth value than large-caps when sectors are compared fairly. While small-caps are projected to deliver 26.6% annual profit growth, investors must balance this against significant liquidity risks and market volatility.
The ongoing debate over whether small-cap stocks are overvalued compared to their large-cap counterparts has taken a new turn. According to Vikas Khemani of Carnelian Capital, the standard way of looking at valuation multiples often paints a misleading picture. While large-cap indices appear cheaper on the surface, this is largely because they are dominated by financial services, global commodities, and IT companies, which naturally trade at lower valuations.
When investors look at domestic, non-financial companies on a like-for-like basis, the story shifts. These businesses within the large-cap space trade at a median of 42 times estimated FY27 earnings, whereas comparable small-cap companies trade at a more modest 30 times. This suggests that for investors seeking pure exposure to India's domestic growth, the small-cap segment may offer better value than broad index multiples imply.
Earnings Growth and Sector Gaps
Profitability trends further support the focus on smaller companies. Projections for fiscal years 2026 to 2028 indicate that small-cap profit growth could reach 26.6% annually, significantly outpacing the 18.7% expected for large-caps.
Beyond just numbers, there is a structural reason for this growth potential. High-growth themes such as electronics manufacturing, railway infrastructure, and private healthcare are heavily concentrated in the mid- and small-cap universe. These sectors have seen robust expansion in recent years, with median annual profit increases of 33% between 2020 and 2026. Because large-cap indices lack significant representation in these emerging industrial areas, investors looking to participate in India’s industrial transformation often find more opportunities in the smaller end of the market.
The Reality of Risks
While the growth potential is compelling, the small-cap segment carries distinct risks that investors should not ignore. The market is not a monolith; performance has been highly uneven. Since April 2023, while some stocks have tripled, many others have lost significant capital. This wide gap in performance makes selective stock picking essential.
Furthermore, liquidity remains a major concern. During market corrections, liquidity in small-cap stocks can dry up quickly, making it difficult for investors to sell their holdings without impacting the price. Recent data also highlights concerns regarding the use of debt to fund these positions. Nithin Kamath of Zerodha has flagged that a significant portion of the industry's Margin Trading Facility (MTF) book—where investors borrow money to buy stocks—is concentrated in small-caps. This high level of retail and borrowed exposure makes the segment vulnerable to panic selling if the market faces a sharp downturn.
For investors, the key monitorables are not just sector growth, but individual company fundamentals. Success in this space depends on identifying businesses with strong management teams, clear competitive advantages, and disciplined use of capital. Given the high inflows into small-cap mutual funds—exceeding ₹55,000 crore in 2026—investors should track whether companies can maintain their earnings trajectory amidst rising input costs and macroeconomic pressure.