The brokerage maintained its January forecast for earnings growth in 2026, expecting large caps to return more than 15% from here, and small caps to outperform over the year, but with a lag. IIFL has expanded its list of top smallcap picks to include PB Fintech, Godrej Properties and Motherson Sumi Wiring, describing them as ‘our version of fallen angels’.The Nifty Smallcap 250 index is up about 4% this month after losing 5.5% of its value in January as the risk-reward ratio gradually improves, although the recovery is expected to be slow and gradual through 2026. Near-term consolidation is likely while market breadth remains limited, market observers said.
Turnaround quarter for small caps?
“The third quarter of FY26 is a turnaround quarter for the smallcap universe in terms of growth, given the fundamental impact and recovery from last year,” said Sanjay Doshi, head of investments and research at Abakkus Mutual Fund. However, he warned that “overall figures may be slightly lower than expected” due to the visible impact of trade uncertainties in export-oriented segments and the gradual domestic recovery.
“The improvement in the outlook for small businesses post-Q3 is largely driven by an alignment between earnings numbers and market sentiment,” explains Sorbh Gupta, head of equities at Bajaj Finserv Asset Management Limited. “While earnings growth in the small and mid-cap sector was already improving, share prices had not reflected this due to continued negative sentiment, especially around global trade and tariff-related uncertainties.”
“With the recent US trade deal and improved visibility on capital flows, that sentiment is now diminishing. As a result, we believe stock price movements should increasingly follow, and in some cases even exceed, earnings growth through selective valuation re-rating,” Gupta added.
Which shares to buy?
Gaurav Bhandari, CEO of Monarch Networth Capital, cited financial services, consumer discretionary and select capital goods companies as sectors reporting better earnings, “supported by credit growth, sustained domestic spending and infrastructure-linked activities.” Manufacturing benefited from policy initiatives and rising capacity utilization, while consumer-facing segments received a boost from ‘government efforts (rationalization of GST structure) to encourage consumption’.
“Furthermore, the recent trade deal with the EU and the US has also improved the overall business prospects for small and medium-sized businesses that are significantly dependent on exports to developed economies,” Bhandari noted.
Gupta highlighted building materials (particularly cement), certain metals and chemicals, banking and finance, consumer-related names and healthcare as attractive sectors. “Cyclic companies see a marked improvement in prospects as demand visibility improves in Q4 and FY27, while liquidity support also becomes clearer.”
Despite the improving picture, analysts urged selectivity. “There is quite a wide disparity in corporate performance across sectors across the small cap universe,” Doshi warned, with companies in EMS, chemicals, automotive, engineering and hospitality doing well, while textiles, food processing and consumer durables sectors were under pressure.
“Smallcaps are still a bit expensive at the index level,” IIFL Capital warned, while Bhandari advised a “bottom-up approach” focusing on “companies with a sustainable business model, excellent corporate governance, good cash flows, high return ratios and a superior capital allocation track record.”
As small caps claw their way back, investors should choose their investments wisely as this is a stock market and not a rising tide that lifts all boats.
(Disclaimer: Recommendations, suggestions, views and opinions expressed by the experts are their own. These do not represent the views of The Economic Times)
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