Small-, mid-cap indices correct 12% in 2025; is market shifting focus from value to quality stocks?

The Indian share market has witnessed persistent volatility in the recent past, with the Nifty50, the Nifty Midcap 100, and the Nifty Smallcap 100 indices correcting 12%, 14%, and 16%, respectively, from their September 2024 peaks. Despite some pull-back rally in the run-up to Union Budget 2025, the Nifty is down 1.8% on a year-to-date (YTD) basis, while the Nifty Midcap 100, and Nifty Smallcap 100 have lost 7% and 11%, respectively, in calendar year 2025.

The sharp correction in small- and mid-cap stocks can be largely attributed to higher valuations, declining profitability, slowing domestic growth, and tight liquidity due to rate hikes by domestic as well as global central banks to tame inflation.

Valuations have dropped 13-16% from the peak and appear attractive, especially large-caps at 17.8x one-year forward earnings. The Midcap 150 and the Smallcap 250 indices are still trading at 45% and 7.5% premiums, respectively, to the Nifty50, as per a recent report by Anand Rathi.

Among others, global economic turmoil, Trump’s policy unpredictability, domestic challenges including slowing growth and foreign fund outflows have also triggered a sell-off in the broader equity market.

Market experts believe that near-term volatility is likely to persist, but medium- to long-term prospects are still bright as valuations have turned attractive after recent corrections in Indian benchmark equities.

Is the market shifting focus to quality from value stocks?

After a strong outperformance of value investors since 2021, the markets are slowly shifting back into growth and quality style after around four years, says Elara Capital in a recent report. “The quantum may not be as sharp as 2017-2020 period (which was triggered post note-ban), but the direction seems to be changing,” the report noted.

Historically, growth has been a style associated with consumption/quality outperformance (both FMCG and discretionary), while value style has been associated with industrial cycle (capital goods, infra, PSU, etc.). The drift from value to growth has largely been seen in case of a weaker market, especially a sharp contraction in breadth, which was visible in the recent trend.

In 2023, the index weight of many value stocks became very large to be ignored, with the PSU weight in the NSE500 Index expanding from 8% to 12% (between Aug’23 to May’24 period), creating a vicious chasing cycle. Since Aug’23, almost 40% of active fund flow moved into sectoral and thematic funds (inflow of ₹1,40,000 crore). Out of this, 21% of these flows went into manufacturing funds (₹28,250 crores); 18% into energy and power funds (₹24,200 crores); 11% into innovation funds (₹15,000 crores); 9% into infrastructure funds (₹12,150 crores); and 6% into PSU funds (₹7,800 crores).

However, for the first time since Sep’24, the market is seeing flows slowing down significantly in these funds and some part of it moving into consumer funds. Also, the NSE500 low price-earnings ratio (P/E) index has started underperforming the main index, the last seen post Covid, resulting in a sharp correction in value stocks, Elara Capital explained in its report.

Echoing this, Nuvama in a recent report says that investors must brace for longer pain in SMID stocks (small- and mid-cap segments of the Indian stock market). While some stocks have already corrected by 50%, valuations are still rich and margins very elevated, making them prone to larger earnings cuts amid a demand slowdown. However, a dovish tone from the U.S. Federal Reserve, rate cut by the RBI, and sizable domestic easing are key to turning bullish.

“BSE400 small and midcap indices are poised for their fifth 20%-plus correction post-GFC (Great Financial Crisis),” it said in a report.

The brokerage house says that the dynamics of the current correction resemble a bear market as the slowdown is now led by domestic credit, and profitability (ex-BFSI) has slipped into contraction. Adding to the woes, durable liquidity has moved into deficit for the first time in the 2020s, and even after the correction, SMID valuations are expensive with 5Y return being 25%, indicating more pain ahead.

What should be the trading strategy?

Despite short-term uncertainties clouding investor sentiment, brokerages believe that in the medium to longer term, macro fundamentals, corporate earnings, domestic flows to the equity market and equity valuations outweigh current concerns. Investors should prioritise investments in high quality large and mid cap stocks as they are often resilient during downturns.

“The lower inflation trajectory, better core sector growth and resilient domestic investment flows continue to underpin market optimism. The RBI’s whopping liquidity infusion and a likely start to the rate-cut cycle in Feb’25, with an expected cut of 25 bps, would give a further fillip to a growth rebound,” Anand Rathi says in a report.

The experts believe that domestic consumption stocks such as FMCG, quick commerce, and retail will be in focus as they are likely to benefit from the income tax cuts announced in Budget 2025. The consumption slowdown has been one of the major concerns for the economy in the recent past. The rise in personal income tax levels will significantly add money into people’s pockets, and is expected to influence consumer behavior, making spending more attractive compared to saving. The anticipated increase in disposable income is poised to drive higher consumption in the FMCG sector, as consumers are likely to allocate a portion of their increased earnings towards everyday goods and services.