Small caps are the heroes of the post-Covid cycle, massively outperforming large caps over five years. Yet H1 FY26 numbers and current valuation bands now tell a more sobering story: earnings momentum has cooled while multiples remain elevated. This blog uses Q1/Q2 FY26 results to explain why the risk–reward in small caps has turned asymmetric and why caution and stock-level discipline are essential.
Performance: From Leadership To Laggard
Over the last 12 months, Nifty Smallcap indices have actually declined around 4%, underperforming Nifty and midcaps, which gained roughly 9% and 8% respectively. However, the five-year picture remains very strong: small caps compounded at about 22% versus 25% for midcaps and 15% for Nifty, implying significant cumulative outperformance still embedded in prices. This long-run rally means investors are sitting on a rich earnings and multiples base just as growth begins to normalise.
H1 FY26 earnings reinforce this moderation. In Q1, Nifty Smallcap 250 delivered about 7% revenue growth but an 8% PAT decline, in sharp contrast to Nifty 500’s 9% PAT growth and midcaps’ 17%. Q2 saw a sharp rebound with 10% revenue growth and 24% PAT growth for Smallcap 250, but this bounce-off a weak base still leaves aggregate H1 growth only modestly ahead of nominal GDP.
Valuations: Market Rich, Small Caps Vulnerable
The Nifty trades at a 12‑month forward PE is about 21.5x versus a 10‑year average of 20.8x, and forward P/B is 3.2x versus a 2.9x average. In other words, even the large-cap benchmark is trading inline to long term average, despite more stable earnings and stronger balance sheets.
Against this backdrop, small caps look more stretched. They come off a five-year 22% CAGR price run and a powerful re-rating phase, yet H1 FY26 earnings show only low double-digit revenue growth and volatile PAT, including a negative Q1 and a highly concentrated Q2 rebound driven by Oil refineries, metals and a few sectors.
Q1 FY26:
- Revenue for Nifty Smallcap 250 grew 7% YoY, in line with Nifty 50 and Nifty 500, but PAT declined 8% YoY due to weakness in autos, cement and consumer services.
- Midcaps still managed 17% PAT growth, highlighting that the quality of earnings momentum had already shifted away from the smaller end of the market.
Q2 FY26:
- Revenue growth improved to 10% YoY for Smallcap 250, matching Midcap 150 and above Nifty 500’s 7%.
- PAT surged 24% YoY, but this was skewed: Companies like Chennai petroleum Corporation Ltd and Mangalore Refinery and Petrochemical swing from loss to Profit and Akzo Nobel had one time exceptional income within the small-cap basket, if we exclude the above three companies then the PAT growth comes to ~11%.
This pattern—one soft quarter followed by a sharp but sectorally narrow rebound—means H1 FY26 earnings do not yet provide broad-based support for the premium multiples implied by the last five years of price performance.
Why Selectivity Is Critical In Small Caps
With the large-cap Nifty already trading near its 10‑year PE/PB averages, any incremental risk premium for small caps must be justified by superior and consistent earnings growth; H1 FY26 fails that test.
Given this backdrop, a broad “buy-the-basket” approach to small caps looks risky. A more sensible strategy is to:
- Focus on large caps which have consistent earnings growth, strong balance sheets and good capital allocation strategy.
- In Mid and Small caps, one must continuously test valuations against delivered numbers rather than narratives, especially after a five-year period of outsized small-cap returns.
In this phase, the data is clear: earnings growth is struggling to keep up with the premium valuations that small caps still command. That makes careful, bottom-up stock selection the only sensible way to participate in this segment not index-level exposure.
