Small Caps Are SINKING

The small-cap universe is grey, dull and wet right now. Its index has sunk over 25 per cent (as of March 3, 2025), with no blue skies in sight. A bottom-up look at this space further highlights the turbulence: over 55 per cent of small-cap stocks are down by more than 50 per cent from their all-time highs. Adding to the funk are industry veterans, many of whom have stated that small caps remain expensive and that SIPs (systematic investment plans) in small-cap funds should be stopped altogether. Basically, the knives are out for small caps right now, much like they have been for Virat Kohli due to his lean Test run. No wonder several investors have joined the panic stations, deciding to cut their losses. This makes short-to-medium-term sense, too, as things can get far worse before the sun breaks through the dark clouds. The reason? Small-cap businesses are, and have been, available at exorbitant prices. The froth in our small caps In our August 2024 cover story, 'The hidden dangers in your soaring mid & small-cap funds', we stated how nearly four out of 10 small-cap stocks traded at more than 50 per cent premium. Fast forward to December 2024, and these companies remained at inflated valuations. As per the market-cap-to-PAT (profit after tax) ratio, a valuation metric, small caps still traded at more than 50 per cent their historical median. The recent downturn hasn't improved matters, as the small-cap space still continues to trade at 31.3 times its profits. Less froth in small-cap funds Unlike individual stocks, mutual funds have the privilege of the fund manager's ability to pick and invest wisely. History is full of such examples. During past market peaks, actively managed small-cap funds have maintained greater valuation discipline. For instance, in FY18, when the BSE 250 SmallCap Index soared to a P/E (price-to-earnings) ratio of 86, actively managed small-cap funds remained far more restrained at around 28. Reason? Mutual funds do not chase the hype blindly. While the broader small-cap market is overheated, small-cap funds are value-conscious and filter out weaker businesses, ensuring investors are not at the mercy of market sentiment. Even in June 2024, when small caps were scaling one high after the other,

This article was originally published on March 17, 2025.