Mid- and Small-Cap Stocks Show Signs of Earnings-Driven Recovery

Mid- and Small-Cap Stocks Enter New Phase of Outperformance

According to PL Capital, mid- and small-cap stocks are poised to outperform large-cap stocks in a sustained manner, driven by stronger earnings growth rather than liquidity-driven momentum. The latest earnings season has highlighted a shift in market leadership, with profit growth in broader-market companies accelerating as earnings momentum for large-cap companies moderates due to weaker global demand, higher input costs, and base effects.

Large-cap earnings growth is slowing down, while mid- and small-cap companies are experiencing genuine margin expansion and operating leverage, rather than just revenue tailwinds. This trend is evident in the recent earnings data, which showed profit after tax growth for Nifty Midcap 150 companies accelerating to 22.9% from 15.5% a year earlier, while Nifty Smallcap 250 earnings growth rose to 22.6% from 17.2%.

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In contrast, Nifty 50 earnings growth slowed to 9.3% from 13.0%. The report argues that this divergence is becoming increasingly important for market positioning, as broader-market valuations have already corrected materially over the past few quarters, even as earnings expectations continue to improve.

PL Capital's analysis suggests that small-cap stocks currently appear the most attractive on a growth-adjusted basis, despite trading at higher headline price-to-earnings multiples. The brokerage's proprietary "risk-on/risk-off" indicator rose to 0.69 in April from 0.42 in December, moving firmly into a "risk-on" zone historically associated with broader-market outperformance.

Market breadth indicators have also strengthened sharply, with nearly 58% of BSE small-cap stocks gaining more than 20% during the month, and 75% of stocks trading above their 50-day moving averages. Additionally, foreign investor positioning has become more selective than during previous risk-off phases, with foreign institutional investor ownership in the Nifty Midcap 150 rising to 16.4% in April from 15.7% a year earlier.

Foreign institutional investor ownership in the Nifty 50, on the other hand, declined during the same period. This trend suggests that foreign investors are reducing exposure to large-cap companies while continuing to selectively add to segments where earnings growth remains stronger and domestic ownership is deeper.

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Despite near-term headwinds such as higher US bond yields, elevated crude oil prices, and persistent foreign outflows, PL Capital argues that domestic macro indicators remain supportive enough to offset some of those pressures. Record GST collections, improving manufacturing activity, and resilient domestic demand continue to provide support to broader market earnings.

PL Capital concludes that the gap between broader-market returns and large-cap returns has historically widened during the early stages of sustained recovery cycles. The current return spreads indicate that the broader market cycle may be "turning" once again in favour of mid- and small-cap stocks.