For investors chasing quick gains, the temptation to follow stories and momentum is high, especially in bull phases. But as market cycles have repeatedly shown, it is not narratives, but fundamentals that stand the test of time.
In this edition of The Golden Thumb Rule, Aniruddha Naha, CIO-Alternates, PGIM India underscores a simple yet powerful principle: sustainable wealth in small caps is built on the back of strong earnings, healthy cash flows, and robust balance sheets—not market hype.
Drawing from years of navigating market cycles, he explains why focusing on business quality and ignoring noise becomes even more critical in the under-researched and highly volatile small-cap universe.
As investors look to navigate current market conditions, Naha’s insights serve as a timely reminder that while price may fluctuate in the short term, it is fundamentals that ultimately drive long-term returns and alpha generation. Edited Excerpts –
Kshitij Anand: Market history shows that small caps often deliver their strongest returns after a phase of sharp correction, not during periods of euphoria. Is it the best time to invest in small caps when they are outperforming, or when they are deeply underperforming?
Aniruddha Naha: That’s a very interesting question. It actually touches upon the full cycle of how small caps perform over time.
Generally, our approach to small-cap investing—and investing in general—is to look at segments of the market when they are beaten down. That is when opportunities emerge. The key framework is to identify whether, within a beaten-down segment, there are interesting ideas backed by strong fundamentals and cash flows, which are being ignored purely due to price action.
So, to answer your question, frankly speaking, we become extremely gung-ho when markets have beaten down small caps. That is when they start fitting into our fundamental parameters—valuations, cash flows, and balance sheet strength. Of course, in small caps, one must also carefully assess the background of management and promoters.
Once that is taken care of, the best time to build a small-cap portfolio is when conditions are reasonably weak, sentiment is negative, but the earnings outlook remains strong or shows clear potential.
Returns, as we have always said, have two components: earnings growth and the possibility of PE re-rating. At the bottom of a cycle, small caps can offer both these drivers—if selected properly.
Kshitij Anand: Under-researched and under-owned companies often create pricing inefficiencies, enabling investors to benefit from discovery-led re-rating. What makes small caps a fertile ground for alpha generation compared to large caps?
Aniruddha Naha: If you look at the market structure, large caps consist of roughly 100 companies, while mid caps include about 150 as defined by the regulator. Small caps begin from the 251st company, and the universe extends significantly beyond that.
In fact, depending on the team’s comfort and research capability, we can go down to even the 4000th company by market cap. This gives us a universe of nearly 3,700 companies to choose from.
In a falling market, when sentiment is negative, that is where opportunities typically emerge. Many businesses tend to be overlooked in sentiment-driven markets, and that is where alpha creation happens over time.
However, generating alpha in small caps requires patience and a longer investment horizon to truly understand how the story plays out.
We strongly believe that this space is highly under-researched—as you rightly pointed out. On average, across the small-cap universe, many companies do not even have three analysts covering them.
This lack of research, combined with a large opportunity set, creates the potential for discovering high-quality businesses through ground-level research and channel checks, especially at the bottom of the cycle.
Over longer periods—5, 10, or even 20 years—data since 2008 shows that the highest alpha generation has come from the small-cap segment, even after accounting for market downturns like the 2008 fall.
Kshitij Anand: Good that you pointed out the importance of timing in the market, because my next question is around that. In fact, short-term flows may reward small-cap investors, but it is time in the market—not timing—that unlocks compounding potential. So, can small-cap investing work without a multi-year investment horizon?
Aniruddha Naha: To put it briefly, it is very difficult—I will tell you why. These are businesses, and the biggest wealth creation I have seen happens when a micro-cap graduates into a small cap, then into a mid cap, and eventually into a large cap. That is where you see earnings growth, scale, and PE re-rating.
Now, these transitions do not happen over short periods. Some of the best-known NBFCs in India today were small caps during the 2000–2010 decade. So, our view is that if you get the business right, you should be willing to hold it for a decade or so, patiently living through cycles.
Typically, over a four-to-five-year period, these businesses go through their own cycles. In downturns, they may see a 20–30% correction. But if you hold on, and your conviction in the business’s scalability, management, and opportunity size remains strong, that is where wealth gets created.
The biggest gains come when you invest in small caps and stay invested over time. Unfortunately, many investors who entered the market post-2020 experienced a strong bull run until 2024 and are now a bit cautious. However, once markets recover, having lived through a correction cycle of 30–40%, they are likely to emerge as far better investors over time.
Kshitij Anand: Sustainable wealth creation comes from focusing on earnings durability, as you rightly pointed out. As small caps evolve—from micro caps to small caps, then to mid caps, and eventually to large caps—factors like capital allocation and governance become critical, not just price. Should small-cap investing be driven by narratives and momentum, or by fundamentals?
Aniruddha Naha: This is something we see across cycles. Towards the later stages of a bull market, narratives and stories tend to dominate, and investment ideas start coming from everywhere. However, our view is that throughout the cycle, it is fundamentals that matter.
Beyond capital allocation and governance, which you mentioned, we also focus on balance sheet quality and the nature of investments made in the business. Another key factor is cash flow generation—particularly operating cash flows.
Fundamentals should be the only barometer for investing in equities, and even more so in small caps, where discipline and rigor are crucial.
In a bull market, investors often feel they are missing out, which can lead to regret and eventually to greed-driven decisions. However, if you have built a strong portfolio at the bottom of a cycle—as we may be seeing today—you won’t capture every opportunity, and that’s fine.
If you stay invested in fundamentally strong businesses and give them time, they tend to outperform not just inflation but also generate alpha over time.
Kshitij Anand: Balance is definitely key. Conviction-led bets combined with diversification across business models can help manage downside while capturing alpha. So, is concentration or diversification the better approach in small-cap investing?
Aniruddha Naha: Frankly, there is no single “better” approach—it depends on individual comfort.
I have seen portfolios with 15 stocks perform exceptionally well, and others with 40–45 stocks also do very well. It ultimately comes down to the investor’s style, comfort level, and depth of understanding of the businesses.
If someone has high conviction in a limited set of businesses, there is no need to diversify excessively—over-diversification can dilute returns.
However, given the breadth of the small-cap universe, maintaining a portfolio of 30–40 stocks can be a prudent way to balance risk while still generating alpha.
So, to answer your question, there is no right or wrong—it depends on the investor’s comfort and the depth of research done to understand the competitive advantages and moats of these businesses.
Kshitij Anand: You have seen many cycles, and I am sure patterns tend to repeat—which brings me to my next question. Small caps typically have higher operating leverage, which amplifies both downturns and recoveries, making them cycle accelerators. So, why do small caps generally underperform at the end of a cycle but outperform at the beginning of a new one?
Aniruddha Naha: The way we look at it, it is largely dependent on earnings. Typically, when companies are small, they start as cyclical businesses. As they grow stronger, you begin to see structural strengths emerge, which help them transition from small caps to mid caps and eventually, over time, to large caps.
There is a fair degree of cyclicality across a large part of the small-cap universe—I would not generalize it for all companies—but many are vulnerable to economic cycles. That said, today’s small-cap segment in India is relatively stronger, particularly due to cleaner balance sheets. In fact, many small caps currently have better net debt-to-equity ratios compared to mid caps and large caps.
Ultimately, it all depends on how earnings play out. If earnings deliver—and this is what we are currently witnessing—small caps are well positioned. Based on Bloomberg estimates, the small-cap segment is expected to deliver the highest earnings CAGR over the next two years, despite having seen the sharpest drawdown.
So, we are less concerned about whether small caps act as accelerators at the top or bottom of a cycle. If these are good businesses with visibility of earnings over the next two to three years, and valuations have corrected meaningfully, we would be very excited to build portfolios at this stage.
Kshitij Anand: In fact, my next question was on earnings growth, and you have already touched upon it. Over the next three to five years, small caps are expected to deliver strong earnings growth. What role does earnings growth play in driving small-cap outperformance?
Aniruddha Naha: Earnings, frankly speaking, are the most important factor. Investors are often driven by price, which is where momentum or fear comes into play. However, as analysts and fund managers, our focus remains on earnings—and even more specifically, on cash flows.
The mismatch between price and fundamentals is what we aim to capture in order to generate alpha.
Looking at Bloomberg estimates, earnings growth for the Nifty over the next two years is expected to be around 14–16%. For mid caps, it is in the high teens. But for small caps, the expected earnings growth over the next two years is significantly higher—around 22–24%.
This outlook is already being validated. Over the last two quarters, small-cap earnings have been strong and have started reflecting this growth trajectory.
In the near term, there may be some impact due to global factors such as geopolitical conflicts, including tensions in the Middle East, which could affect earnings across market capitalizations for a couple of quarters. However, markets are forward-looking. Any resolution or positive development could trigger a sharp rally.
So, our view is that earnings are extremely important, and the strength of earnings in small caps is already visible—not just a future expectation. Combined with current valuations, we are comfortable building portfolios at this stage.
Kshitij Anand: Is small-cap investing inherently risky, or is poor stock selection the real risk? Should investors buy small caps when they appear strongest or when they seem weakest?
Aniruddha Naha: Generally, we prefer to invest when sentiment is weakest, as that is when the gap between fundamentals and price is the widest.
As for risk, the biggest risk in small-cap investing is the mortality of a company—the possibility that the business may not survive. If that risk is addressed, then over time, businesses tend to evolve and grow.
To assess this, we closely examine historical cash flow generation and the strength of the balance sheet. Along with credible management and promoters, these factors help mitigate risk significantly.
Beyond that, what investors often perceive as risk is actually volatility. Small caps tend to be more volatile due to earnings cycles, which leads to sharp price movements.
Therefore, investors in small caps must be mentally prepared for volatility. As long as they are confident that the businesses they have invested in are fundamentally strong and not at risk of failure, significant wealth can be created over time.
In fact, some of the greatest wealth creation comes from identifying strong small and micro-cap businesses that, over time, scale up to mid-caps and eventually large caps.
(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)