'A year of negative returns isn't a worry in small caps'

Summary: After a bruising year for small caps, is this a warning sign or just a pause in a longer journey? A fund manager shares how he’s reading earnings, valuations and volatility, and why patience may matter more now than bold calls. After a year marked by narrow market leadership and sharp sectoral swings, Ajay Khandelwal believes the recent pain in small caps is more a pause than a problem. The Fund Manager at Motilal Oswal Asset Management Company, who oversees 15 schemes, including the Motilal Oswal Small Cap Fund, argues that one year of underperformance should be viewed against much stronger long-term earnings growth and balance-sheet repair across the segment. While 2025 has been challenging, he points out that valuations have cooled, time corrections have replaced earnings downgrades, and a growing pool of high-quality companies is now available at more reasonable prices. In this interview, Khandelwal explains how stock selection, earnings visibility and patience shape portfolios in a market where volatility has returned but fundamentals remain intact. What feels most different about the equity market today compared to a year ago, in terms of earnings trends and sector leadership? We started the calendar year 2025 with a lot of uncertainty. From January to March, if you think about it, many things happened. The RBI’s stance was more focused on rupee stability, and as a result, liquidity became a concern in the markets. From our channel checks, we understood that businesses were going through a difficult phase. During the year, some of these uncertainties persisted around tariffs and supply chains, and now even commodity prices, especially non-ferrous, are affected. The way they have been behaving has created additional margin challenges. These are some of the factors that, I think, have dragged more than anticipated. But I would like to add something here, especially on small caps. One year of negative returns is not worrisome in the larger context. Over the last seven or eight years, the small-cap category has seen deleveraging of almost 30 per cent, while earnings growth has nearly tripled. So, for small caps, if the balance sheet is healthy and growth is strong, a one-year discrepancy is more like a pause, especially given that the small-cap index still delivered more than 20 per cent-plus CAGR over the last three and five years. This year has been challenging, yet markets have been resilient. Could you walk us through how you think about portfolio construction more broadly? How do valuations and common holdings fit into this framework, and how should investors set the right expectations around return patterns and volatility? How do the AMC’s funds differ from more diversified peers? I will give you some perspective using this year’s small-cap and mid-cap environment. Take smal