Indian small-cap stocks had an extraordinary run in FY2023-24, with the Nifty Smallcap 250 delivering nearly 65% against the Nifty 50's 29%. The 2024 SEBI-driven disclosure requirements and subsequent caution from fund houses on small-cap valuations initiated a correction. By end of FY2025-26, small-caps had underperformed large-caps by approximately 15-20% cumulatively.
What drove the small-cap correction
Valuation reversion: At peak, the Nifty Smallcap 250 PE touched 34x — a historic extreme. The correction brought it to approximately 22-24x, closer to its 10-year average of 20x.
SEBI disclosure pressure: SEBI's March 2024 circular requiring AMCs to disclose if they believed small-cap funds were operating in the investor's interest — given elevated valuations — led several fund houses to pause lump-sum inflows, removing a marginal buyer.
Earnings disappointment: Several small-cap companies that benefited from post-COVID capex cycles reported earnings misses in FY25 as government capex timing shifted.
Where valuations stand now
| Index | Current PE | 10-Year Avg PE | Premium/Discount | |---|---|---|---| | Nifty 50 | 21x | 21x | At average | | Nifty Midcap 150 | 28x | 24x | +17% premium | | Nifty Smallcap 250 | 23x | 20x | +15% premium |
Small-caps have derated significantly but remain above long-term averages. They are not cheap, but they are not the extreme bubble of 2024 either.
Historical small-cap cycle lessons
Looking at 5 prior instances where small-caps underperformed large-caps by 15%+ over a 12-month period: - In 4 of 5 cases, small-caps outperformed in the subsequent 3 years - Average 3-year outperformance after a correction: 12% cumulative - The outlier (2008-2011): prolonged underperformance due to macro recession
Portfolio implications
For investors with a 5+ year horizon and existing small-cap SIPs: continue. The correction has improved the entry point meaningfully from 2024 peaks. For investors considering fresh small-cap allocation: a staggered SIP entry over 12-18 months is prudent given that valuations are below peak but not at historical lows. Avoid making small-caps more than 20-25% of your equity portfolio — the volatility is real and requires strong conviction to hold through drawdowns.