Indian Small-Caps Run Risk of Extended Selloff as Earnings Slow

The Indian small-cap market, once a darling of investors, is currently grappling with a significant selloff. This downturn is not a mere blip but a reflection of slowing earnings growth and elevated valuations. As foreign institutional investors (FIIs) retreat, the market's trajectory remains uncertain, raising concerns about the sector's resilience.

The current selloff in Indian small-caps is not unprecedented, but it is a stark reminder of the market's volatility. While the 2018 correction was more severe, the ongoing selloff is a wake-up call for investors who have been riding the small-cap wave. The Nifty Smallcap250 index is trading at around 22 times earnings per share (EPS) on a one-year forward basis, a 21% premium to its historical average and almost 50% higher than valuations around March 2018 levels.


The role of FIIs in the recent selloff is significant. Their net outflow of ₹2,261.83 crore in the capital market segment has exacerbated the market's decline. FIIs have been selling Indian equities to invest in relatively cheaper locations such as China, as noted by Prashanth Tapse, Senior VP (Research) at Mehta Equities Ltd. This shift in investment strategy has contributed to the increased volatility in the Indian market, as reflected in the India VIX's 4.60% rise to 14.3950.


Earnings growth in small-cap companies has slowed down, contributing to the ongoing selloff. While the smallcap250 index has seen a 26% compound annual growth rate (CAGR) in earnings over the past two years, the pace of growth has decelerated. This slowdown in earnings growth, coupled with elevated valuations, has made small-caps less attractive to investors.

The sectors most vulnerable to the current market conditions include PSU banks, which have been hit hard by the selloff, and other cyclical sectors. On the other hand, defensive sectors such as consumer goods and pharmaceuticals may offer resilience during this period of uncertainty.


The recent surge in volumes and inflows to mutual fund schemes has not been enough to offset the selling pressure in the small-cap space. While retail investors may be concerned about the sharp slide in midcap and smallcap shares, the ongoing correction is not a 'meltdown,' as highlighted by foreign brokerage Jefferies. However, the market's trajectory remains uncertain, and more correction cannot be ruled out.

The RBI's latest bulletin, which upholds India's GDP growth forecast of 7.2% for FY25, suggests that the Q2 slowdown is temporary. Festive season consumption is expected to rebound, offering a silver lining amid the market turbulence. However, investors should remain cautious and monitor the market's trajectory closely.

In conclusion, the Indian small-cap market is facing an extended selloff due to slowing earnings growth and elevated valuations. The role of FIIs in the recent selloff is significant, and their behavior will impact the market's trajectory. Investors should remain vigilant and monitor the market's performance closely to make informed decisions.