Last week, the CNX SmallCap 100 index cracked by 7.3%. On Monday, it crashed a further 4%. The last time the index fell more than this was way back in December 2022 (8.33%). This serious decline comes after months of churning, with the index trying, but unable, to head higher. With the benefit of hindsight, the index topped in mid-September 2024 and has been slowly edging its way down, with big declines in the third week of October (down 6.45%) and early-November 2024 followed by the sharp fall last week.

The two key market indices, the NIFTY and the Sensex, peaked on 27th September and are down 11% today. Foreign institutional investors (FIIs) have been relentless sellers during this period.

Until early-December, it seemed that the smaller companies would buck the downtrend. Does the current brutal selloff signify a different scenario? Let us look at a few facts.

A K-shaped economic growth refers to some parts of the economy experiencing strong growth, while others continue to decline, like two arms of the letter 'K'. The worst kind of K-shaped growth is when a small number of rich people do very well, while the vast majority languishes.

We had a K-shaped growth in the stock market as well, but it is the opposite of K-shaped economic growth; the business of blue-chip, cash-rich, mega companies with access to the best resources struggled to grow, while smaller companies surged ahead.

Since March 2023, indices tracking micro-cap, small-cap and mid-cap stocks have risen relentlessly. The Nifty SmallCap 100 index doubled in the 18 months between April 2023 and September 2024. There was a small correction in March 2024 and one coinciding with the election setback to the Bharatiya Janata Party (BJP) in June 2024. But small stocks shrugged off the setback.

Investors argued that prime minister (PM) Narendra Modi with the same Cabinet signalled continuity of leadership and the market would continue to rise, unhindered by political uncertainties. The assumption looked valid, as coalition partners Chandrababu Naidu and Nitish Kumar looked content to remain in their home states and did not threaten to destabilise the government. The transition to PM Modi's third term has been so smooth that we tend to forget that he is now heading a coalition government.

In further support of the theory that 'nothing has changed', the Budget continued with its massive capital expenditure (capex) (Rs11 lakh crore for the third year running). This was immediately a bullish indicator for smaller companies. They are the main beneficiaries of government spending on renewable energy, electricity transmission & distribution (T&D), defence production, urban transportation, railways, water supply, supportive light engineering and construction.

That apart, smaller companies also dominate fast-growing and new businesses like electronics manufacturing services (EMS), healthcare services (hospitals and diagnostics) and a variety of sunrise sectors such as recycling, smart metering, data centres, consumer technologies and non-fund retail financial services such as stockbroking and wealth management.

On the other hand, the mega-cap companies are in software services, consumer goods, banking, telecom, automobiles, pharmaceuticals and commodities which are mature, slow-growing businesses. Banks were supposed to benefit from infrastructure spending but ,with the government and capital markets supplying the cash for growth, who needs banks?

To grow, banks and finance companies increased consumer and personal loans. But these have turned problematic as income growth for the masses has not kept pace with actual inflation on the ground—a by-product of K-shaped economic growth. This is also why consumer companies are not doing well.

Once the trend of smaller companies doing well was underway, equity funds either launched new small-cap funds or started promoting existing ones aggressively. The thesis was that smaller companies were undergoing 'structural growth' which would continue for a very long time. But just as this thesis has become wildly popular, doubts have started to creep in.

Over the past three months, my columns have repeatedly highlighted the fact that the Indian economy is reverting to normal after three years of high growth. This was reflected in the stock prices of companies in major sectors such as passenger cars, consumer goods, banks and financial services. For two months, smaller companies bucked the trend—for genuine reasons.

The heroes of India's growth in the past few years have been smaller, efficient companies in the sectors I have described above. Are they about to slow down as well? Usually, significant stock price changes signal a regime change, well before the change becomes apparent. Stocks discount the unknown future, not the known past.

In my view, we will probably see a divergence within the small-cap universe. Businesses that are dependent on government spending may be negatively affected unless there is a strong pick-up in spending. Sectors that are unaffected by government policies—drug research, consumer technology, outsourced business services, outsourced manufacturing, healthcare and some older traditional businesses like light engineering and automotive components, with a focus on exports —will continue to do well. These are now the real bright spots of India's corporate sector, just as software exports, banking, pharmaceuticals and consumer products were two decades ago. But that does not mean that returns would match those of the past two years.

Great returns are a function of low valuation plus unexpectedly high growth. Valuations are no longer low now, even in the hot segment of the small-cap universe and high growth is not a surprise. One must temper expectations accordingly, although these are the businesses of the future and would continue to do very well.  

(This article first appeared in Business Standard newspaper)