India's Smallcap Opportunity: Why the Real Story Lies Beneath the Index

Resilience + Rate Cuts + Reforms = Recovery | Smallcaps Better Placed for Superior Returns

1. The Index Is Hiding the Real Correction

Indian equity markets have undergone a severe, broad-based correction over the last 18 months (since September 2024) — yet most investors don't see it because headline indices like Nifty 50 remain near all-time highs. The divergence is stark:

• ~80% of all listed companies above Rs 1,000 cr market cap are in bear market territory (down 20%+ from all-time highs)
• ~64% have fallen 30%+ from their peaks
• ~48% have fallen 40%+ from their peaks
• Despite this, Nifty 50 is down only 3%, and the Nifty Smallcap 100 Index is down just 13%

Why the gap? A narrow set of index heavyweights has continued to hold up while the vast majority of smaller, high-growth companies have corrected deeply. This creates a misleading sense of market stability — and a genuine opportunity for discerning investors.

2. Corporate India Is Stronger Than It Has Been in 20 Years

One of the most under-appreciated stories in Indian markets today is the extraordinary health of corporate balance sheets — and the fact that smaller companies are now growing faster than their larger peers.

Balance Sheet Strength (Top 500 Non-Financial Firms)

• Net Debt/Equity has fallen to 0.32x — the lowest level in 20 years
• Capex has accelerated to Rs 9.5 lakh crore with a 3-year CAGR of 18%
• Operating Cash Flow (OCF) and Profit Before Tax (PBT) trajectories remain solid
• Capex as % of revenue is rising but still well below the previous peak of ~12%

Smaller Companies Outpacing Larger Peers (FY19-FY25, 6Y CAGR)

• PBT CAGR: ~20% for smaller companies vs 12.4% for larger companies
• PAT CAGR: ~25% for smaller companies vs 13.9% for larger companies
• Net Debt/Equity for smaller companies has collapsed to 0.13x
• Revenue CAGR (last 3 years): 14% for smaller companies vs 11% for larger ones

Earnings growth showed early signs of revival in Q3FY26. Median operating profit for companies in the Rs 500 cr to Rs 50,000 cr market cap bucket grew 14.1% YoY in Q3FY26, ahead of the 12.1% YoY growth seen in larger companies.

3. Rate Cuts: History Strongly Favours Smallcap Investors

The RBI has already executed rate cuts of 125 bps from the peak. Every rate cut cycle of 100 bps or more in the last 25 years has been followed by sharp recovery in the smallcap index over the subsequent 1-2 years.

Historical NIFTY Smallcap 100 Returns Post Rate-Cut Cycle

• 2001-2003 cycle (cut of 400 bps): -8.5% in 1 year, +91.8% in 2 years post easing
• 2008-2009 cycle (cut of 425 bps): +99.1% in 1 year, +105.3% in 2 years post easing
• 2011-2013 cycle (cut of 125 bps): +21.8% in 1 year, +68.7% in 2 years post easing
• 2019-2020 cycle (cut of 225 bps): +136.0% in 1 year, +137.2% in 2 years post easing

The current cycle began on 6 February 2025. Based on historical precedent, the 1-2 year window post the easing cycle has been the best time to be invested in SMID equities.

Why do rate cuts particularly benefit smallcaps? Smaller companies benefit from operating leverage as economic activity picks up; lower borrowing costs directly boost margins; and improved growth delivery leads to valuation re-rating. With CPI inflation at just 2.8% YoY (January 2026, new base year series), there is meaningful room for RBI to maintain an accommodative stance.

4. Reforms: The Structural Multiplier for the Indian Economy

The Government of India has significantly accelerated the pace and intensity of its reform agenda in the past 12 months, creating a structural springboard for organized sector growth across industries.

Key Recent Policy Catalysts

• Income Tax rebate and cuts — Rs 1 lakh crore benefit to citizens
• GST cuts — Rs 48,000 crore benefit in FY26, Rs 96,000 crore in FY27
• Bottom-of-pyramid income support — Rs 96,000 crore in FY26, Rs 1.92 lakh crore in FY27
• Interest rate cuts — Rs 1.87 lakh crore aggregate stimulus
• 8th Pay Commission — additional Rs 2.4-3.2 lakh crore consumer spend
• Trade deals with US, EU, New Zealand, and others
• 100% FDI in Insurance and nuclear sector reforms
• Viksit Bharat Rozgar Guarantee (Gramin) Act, 2026 — Rs 39,000 crore for rural employment

These reforms are not just short-term stimuli. The combination of formalization of the economy (GST, digital payments, direct benefit transfers), PLI schemes, infrastructure spending, and demographic tailwinds creates a durable multiplier effect that particularly benefits organised, listed businesses over informal competitors.

Economic Activity: Indicators Turning Green

Domestic economic indicators have shown material improvement from November/December 2025 onwards:

• Manufacturing PMI remains strong at 55.4 (January 2026)
• Services PMI sustained at 58.5 (January 2026)
• Eight Core Industries Index rebounded sharply in December
• Auto retail sales surged — two-wheelers +21.4% YoY, passenger vehicles +7.2% YoY in January 2026
• GST E-Way Bills up 15.8% YoY in January 2026
• Credit growth picked up to 14%+ as per the latest RBI bulletin

5. FII Flows: Positioned for a Comeback

Foreign Institutional Investor (FII) flows into India have been persistently weak over the past several years. Net cumulative FII equity flows over the last 5 years stand at negative US$11 billion — a strikingly small number given India's current market capitalisation of approximately US$5 trillion.

However, this underweight positioning creates a powerful re-entry catalyst:

• FII ownership in Indian stocks has fallen from a high of 22.5% to below 17% (December 2025)
• DII inflows have more than compensated, with Rs 224 lakh crore cumulative over 5 years vs FII outflows of US$11 bn
• The breadth of investible liquid Indian companies has tripled since 2015 — over 580 companies now exceed US$1 bn market cap
• Strong fundamentals, improving earnings, and reform momentum make India increasingly attractive for global allocators

6. Portfolio Positioning: Monarch AIF's Approach

Monarch AIF's two live funds — MNCL Capital Compounder Fund I and MNCL Capital Compounder Fund II — remain tilted heavily towards quality smallcap companies offering high earnings growth at reasonable valuations. The portfolios deliberately avoid momentum-driven or theme-based stocks and those trading at very elevated valuations.

MNCL Capital Compounder Fund 2 (Inception: April 2024 | AUM: ~Rs 800 cr):

• Portfolio: 25 stocks | 78% smallcap, 22% largecap (as per SEBI classification)
• FY27E P/E: 21.2x | Expected EPS CAGR FY25-27E: 28.1%
• 12-month return: +13.4% vs Nifty 500 TRI +13.4%
• Since inception CAGR: +8.5% vs Nifty 500 TRI +8.9%

MNCL Capital Compounder Fund I (Inception: August 2022 | AUM: ~Rs 115 cr):

• Portfolio: 16 stocks | 68% smallcap, 27% largecap (as per SEBI classification)
• FY27E P/E: 21.4x | Expected EPS CAGR FY25-27E: 29.2%
• 12-month return: +5.0% vs Nifty 500 TRI +13.4%
• Since inception CAGR: +11.7% vs Nifty 500 TRI +14.4%

FREQUENTLY ASKED QUESTIONS (FAQS)

India Smallcap & Midcap Markets | Rate Cuts | Reforms | February 2026

Section A: Market Conditions & Valuations

• Q1. The Nifty 50 is near its all-time high. Why does Monarch AIF say the market is in bear territory?
  The Nifty 50 is driven by a small number of large-cap heavyweights that have held up well. However, beneath the surface, more than 80% of all listed companies above Rs 1,000 crore market cap have fallen 20% or more from their all-time highs — which is the textbook definition of a bear market. Over 64% have fallen 30%+. This is a broad-based correction that index-level data simply does not capture.
• Q2. Are SMID (smallcap and midcap) index valuations now cheap?
  Not at the index level — the SMID Median TTM P/E is currently around 36x, well above its long-term average of 20x. This is because SMID indices are dominated by larger companies within the mid and small cap universe (as per SEBI's size-based classification). However, at the individual stock level, around 36% of companies above Rs 1,000 crore market cap are now trading below 25x TTM P/E, up from just 25% in September 2024. Several quality, fast-growing small companies are now available below 20x 1-year forward P/E — levels that have historically offered attractive returns.
• Q3. Is this a good time to invest in smallcap equities?
  Monarch AIF believes the current environment offers one of the most attractive entry points for smallcap equities in nearly five years. Three factors converge: corporate balance sheets are at their strongest in 20 years, a rate-cut cycle is underway, and a significant reform agenda is supporting domestic demand. Broad-based correction at the individual stock level has improved risk-reward considerably for patient, quality-focused investors.
• Q4. What is the risk of further index-level correction even from current levels?
  Index-level valuations (especially for SMID indices) remain elevated and may see further time correction or earnings-driven de-rating among high-multiple stocks. Monarch AIF expects index returns to remain range-bound, while bottom-up stock selection in quality smallcaps could meaningfully outperform the broader index. Starting valuations, earnings growth trajectory, and stock selection discipline are the key differentiators.

Section B: Corporate Health & Earnings

• Q5. How strong are Indian corporate balance sheets today?
  Extremely strong — and improving. An analysis of the top 500 non-financial listed companies shows that Net Debt/Equity for corporate India has fallen to just 0.32x, the lowest level in 20 years. Capex is accelerating (Rs 9.5 lakh crore, 3-year CAGR of 18%), while OCF and PBT trajectories remain solid. This creates significant headroom for companies to reinvest, expand, and grow earnings organically.
• Q6. Are smaller companies really growing faster than large companies?
  Yes — and the data is compelling. Among the 251st to 500th largest non-financial companies by revenue, the 6-year (FY19-FY25) PBT CAGR was approximately 20% and PAT CAGR was approximately 25%, well ahead of larger peers. Their Net Debt/Equity has collapsed to 0.13x — even lower than large-caps. Revenue CAGR over the last 3 years was 14% for smaller companies versus 11% for larger ones.
• Q7. When are earnings expected to recover?
  Earnings growth showed early signs of recovery in Q3FY26. Median operating profit for companies in the Rs 500 cr to Rs 50,000 cr market cap bucket grew 14.1% YoY in Q3FY26, slightly ahead of larger companies at 12.1%. With domestic demand holding up, GST stimulus working through the system, and improved export prospects post trade deals with the US and EU, Monarch AIF expects continued earnings improvement in Q4FY26 and meaningful upgrades for FY27E.

Section C: Rate Cuts & Monetary Policy

• Q8. How significant is the current RBI rate cut cycle for equity markets?
  The RBI has already cut rates by 125 bps from the peak, and the new CPI inflation reading for January 2026 came in at just 2.8% YoY (new base series), well within the RBI's comfort zone. Historical analysis of every rate cut cycle involving 100 bps or more over the last 25 years shows that the Nifty Smallcap 100 Index has delivered very strong returns in the 1-2 years following the easing cycle — regardless of the macro backdrop at the start of the cycle.
• Q9. Why do rate cuts benefit smaller companies more than large ones?
  Three reasons: first, rate cuts stimulate economic activity, which boosts revenues and operating leverage — a disproportionate benefit for smaller companies that tend to have higher fixed costs relative to revenues. Second, lower interest rates directly reduce borrowing costs, allowing smaller companies to take on growth capital more affordably. Third, improving earnings delivery leads to P/E re-rating, which is typically more pronounced in smallcaps that had been de-rated during tight monetary conditions.
• Q10. Is there a risk that RBI reverses course and raises rates?
  Currently, the risk is low. CPI inflation at 2.8% (January 2026, new series) is comfortably below the RBI's 4% target. The new CPI series increases the weight of core inflation (excluding food and fuel) from 47.3% to 57.9%, and core CPI (excluding precious metals) stands at just 1.9%. This structural shift in the CPI basket makes it easier for RBI to maintain accommodative policy as food price volatility has less index impact than before.

Section D: Government Reforms & Economic Activity

• Q11. Which government reforms are most impactful for the stock market?
  The most immediate market catalysts are income tax cuts (Rs 1 lakh crore benefit), GST reductions across multiple categories (Rs 48,000 crore in FY26, Rs 96,000 crore in FY27), and the upcoming 8th Pay Commission (Rs 2.4-3.2 lakh crore additional disposable income). Structural long-term catalysts include PLI schemes, 100% FDI in insurance, trade deals with the US and EU, MSME ease-of-doing-business reforms, and the Viksit Bharat Rozgar Guarantee Act.
• Q12. Is domestic economic activity actually improving?
  Yes, with clear signs of improvement from November-December 2025 onwards. Manufacturing PMI is at 55.4 and Services PMI at 58.5 — both well above the 50-mark indicating expansion. Auto retail sales, particularly two-wheelers (+21.4% YoY) and tractors (+22.9% YoY), have bounced back strongly post GST cuts. GST E-Way Bills are up 15.8% YoY, credit growth has risen to 14%+, and digital payments volume is growing 22.3% YoY.
• Q13. What is the outlook for FII flows into India?
  Monarch AIF expects net FII flows to improve from currently subdued levels. FII ownership in Indian listed stocks has fallen to below 17% from a high of 22.5% over the last decade — a decade-low. With improving earnings, a supportive reform environment, and expanding market breadth (over 580 Indian companies now exceed US$1 bn in market cap, triple the 2015 count), India is becoming increasingly attractive for global institutional allocators. The scale of FII underweight in India today is itself a potential return catalyst.

Section E: Monarch AIF Funds

• Q14. What is Monarch AIF's investment philosophy?
  Monarch AIF focuses on quality smallcap companies with strong earnings growth potential, available at reasonable valuations. The portfolios avoid momentum-driven or thematic stocks and actively steer away from companies with very high valuations. The approach is fundamentals-first, bottom-up stock picking with disciplined risk management — a style that has historically rewarded investors most during recoveries from broad-based market corrections.
• Q15. What are the key metrics of Monarch AIF's current portfolios?
  MNCL Capital Compounder Fund 2 (AUM ~Rs 800 cr, inception April 2024): 25 stocks, 78% smallcap, FY27E P/E of 21.2x, expected EPS CAGR of 28.1% (FY25-27E), 12-month return of +13.4%. MNCL Capital Compounder Fund I (AUM ~Rs 115 cr, inception August 2022): 16 stocks, 68% smallcap, FY27E P/E of 21.4x, expected EPS CAGR of 29.2% (FY25-27E), since-inception CAGR of +11.7% vs benchmark +14.4%. Both portfolios are positioned for superior returns in FY27-28 as the earnings recovery cycle matures.
• Q16. How is Monarch AIF managing risk in the current environment?
  Risk management at Monarch AIF focuses on three dimensions: valuation discipline (avoiding high P/E stocks with uncertain earnings delivery), balance sheet quality (preference for low-debt, high-cash-flow companies), and diversification across sectors. The portfolios are positioned in companies with strong internal cash flows to fund growth — reducing dependence on external capital. Both funds are over 95% invested, reflecting conviction in current entry points.
• Q17. What is the investment horizon that Monarch AIF recommends?
  Historical data on rate cut cycles and broad market recoveries suggests that the 1-2 year window following a significant rate easing cycle has been the most rewarding for smallcap investors. Monarch AIF's earnings estimates project meaningful acceleration in FY27 and FY28. Investors with a minimum 2-3 year horizon are best positioned to capture the potential upside from the current entry point — both from earnings growth and from potential valuation re-rating as market sentiment improves.