Is the smallcap rally a trap? Only 37% of stocks are outperforming their benchmark

Only 37.2% of stocks in the Nifty Smallcap 250 have outperformed the benchmark in 2026, the lowest proportion in eight years, even as the index delivered the strongest return among large, mid and smallcap benchmarks, according to a YES Securities report.

The divergence suggests that headline returns are being driven by a shrinking pool of winners rather than broad participation. While 24% of smallcap stocks have gained more than 25% this year, most constituents have failed to beat the index, raising the execution risk for investors chasing the segment’s recent performance.

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The picture is almost the reverse in largecaps. About 65% of Nifty 100 constituents are outperforming their benchmark, the highest level in eight years and sharply above 46.5% in 2025. That breadth improvement has emerged despite the Nifty 100 underperforming the broader market, indicating that largecap weakness is concentrated in a relatively small group of stocks.
Across the NSE 500, market participation has improved materially. About 54.9% of constituents are beating the Nifty 500, up from 36.4% last year and the second-highest reading in eight years. But the rewards from picking outperformers are diminishing: median alpha generated by winning NSE 500 stocks has slipped to 18.3% from 19.1% in 2025 and remains well below the 37.5% peak recorded in 2021.

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The market is, therefore, becoming broader but less rewarding at the individual-stock level, turning the next phase of the rally into a more demanding stock-picker’s market.“Investors almost always chase recent returns,” said Shridatta Bhandwaldar, chief investment officer-equities at Canara Robeco AMC. “Small and mid-caps have sizably outperformed large caps over the last 3 years and thus those categories have been receiving larger flows.”

That pattern remains visible in mutual fund allocations. Smallcap funds received net inflows of ₹7,770 crore in July, the highest among equity-oriented categories, while midcap funds attracted ₹6,190 crore. In contrast, largecap funds recorded net outflows of ₹1,320 crore.

Bhandwaldar said investors should not overlook the margin of safety available in largecaps, though their performance would require an improvement in earnings momentum.

“The challenge is that a few large cap sectors like large banks, IT, FMCG, O&G have lacked earnings acceleration over the last few quarters,” he said. “That needs to change.”

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Earnings provide support

The smallcap rally is not entirely disconnected from fundamentals. Smallcap companies covered by Motilal Oswal delivered 31% year-on-year earnings growth in the June quarter, comfortably ahead of its 22% estimate. About 75% of the smallcap coverage universe met or exceeded expectations.

Financials and oil and gas led the earnings performance, while NBFC lenders, private banks, NBFC non-lenders and chemicals also contributed. Together, these sectors accounted for about 69% of the incremental year-on-year increase in smallcap earnings.

The forward earnings differential also remains in favour of smaller companies. FY27 profit growth is estimated at about 16% for the Nifty 100, 20% for midcaps and 34% for smallcaps, according to Venugopal Manghat, chief investment officer-equity at HSBC Mutual Fund.

“This provides room for mid and smallcaps to catch up with earnings,” Manghat said. “However, given that smallcaps continue to trade at a premium, selectivity remains critical, with a focus on balance sheet strength, cash flow visibility and sustainable returns.”

Manghat said the valuation gap alone does not justify a decisive move toward largecaps, particularly as key largecap sectors such as information technology and consumer staples may continue to face weak earnings growth. Manufacturing-led opportunities, meanwhile, are more heavily represented among mid and smallcap companies.

“Our preference remains a diversified approach across market caps, driven by stock-level opportunities rather than a binary large-cap versus mid-/small-cap call,” he said.

The valuation fault line

Elevated valuations complicate the investment case despite stronger earnings. Mid and smallcap stocks were the primary drivers of market performance in the first half of 2026, supported by retail and domestic institutional flows, resilient economic growth and improving earnings expectations. Manufacturing, capital expenditure, defence, infrastructure and consumption-linked companies were among the key beneficiaries.

But the sharp appreciation has reduced the margin for error, particularly where valuations already assume sustained high growth.

Pawan Bharaddia, co-founder and CIO at Equitree Capital Advisors, said dispersion within market cap segments is now greater than the differences between them, making broad allocation calls less useful.

“The broad midcap segment is where we would currently exercise the most valuation discipline,” he said. “Median valuations remain high, median PEG ratios in our work remain above 2, and nearly seven out of ten companies in our analysed midcap universe were trading above 30x trailing earnings.”

Bharaddia continues to see mispricing opportunities among select small and microcap companies, particularly in the ₹1,000 crore to ₹5,000 crore market-cap bracket. But that does not mean the overall segment is inexpensive.

“We are not looking for inexpensive companies because they are small,” he said. “We are looking for businesses capable of compounding earnings at 20% plus, with strong balance sheets, capable management, improving competitive positions and sensible valuations.”

Midcap breadth has remained relatively stable, with 42.9% of Nifty Midcap 150 stocks outperforming the benchmark, broadly in line with the five-year average. However, median alpha in the segment has dropped sharply to 15.5% from 21.8% in 2025.

The proportion of stocks delivering gains above 25% has also declined to 15% among largecaps and 16% among midcaps, from 24% in both categories last year. Returns are increasingly clustering around moderate gains and declines, further shrinking the universe of outsized winners.

Hemant Kanawala, senior executive vice president and head of equity at Kotak Life Insurance, said largecaps offer valuation comfort, particularly in banks and IT, while mid and smallcaps remain a source of alpha because of their exposure to faster-growing sectors.

“We favour financials, hold quality compounders across the cap curve, and prefer mid and small cap selectively for an alpha kicker,” Kanawala said. “A durable leadership shift ultimately needs earnings to sustain it.”

The smallcap rally may not be a trap in its entirety. Earnings growth remains strong and a meaningful subset of companies continues to deliver outsized gains. But with participation at an eight-year low, premium valuations and widening dispersion, buying the benchmark’s recent success indiscriminately carries growing risk.

(Disclaimer: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of The Economic Times)