Are Small Cap & Mid Cap Funds Overvalued?

Small-cap and Mid-cap mutual funds are experiencing a surge in investors' interest. The inflow into small-cap funds jumped to 22.6% at ₹5,720.87 crore and mid-cap funds rose to ₹5,147.87 crore in January 2025 which is an all-time high. 

However, concerns around valuations and market volatility have also emerged. Are we witnessing a sustainable growth phase or is this a bubble waiting to burst? In this article, let’s look at investor sentiment, valuation and inflows of these funds.

What Are Small-Cap & Mid-Cap Funds?

As per SEBI, companies are categorized into large, small and mid-cap by their market capitalization. Large-cap companies are the first 100 companies in the stock market ranked by their market capitalization. Mid-cap are 101st to 250th and small cap are companies that rank 251st and beyond. 

Large-cap companies are well-established companies with consistent earnings. They are market leaders in their industry. Popular large-cap companies include Reliance, TCS, Britannia, etc. 

Mid-cap companies are more established than small-cap companies. Some popular mid-cap companies include BSE, Suzlon Energy, Policy Bazaar, etc. 

Small-cap companies on the other hand are emerging businesses and are often characterised by their high-growth potential. Examples of small-cap companies include Blue Star, Glenmark, CDSL,etc.

Why Do People Invest In Small Cap, Mid Cap & Large Cap?

Large-cap companies are market leaders in their industry. Investors invest in these companies because they have strong brand trust and are known for being less volatile during market swings as compared to mid-cap and small-cap. Large-cap mutual funds invest at least 80% of their assets in large-cap companies.

Small-cap companies on the other hand are growing businesses and their stocks are more volatile than large-cap companies. If a small-cap company performs well, it holds the potential to provide decent returns to investors, which makes it an attractive option for investors willing to take on more risk for higher returns. Small-cap mutual funds invest at least 65% of their assets in these companies.

Mid-cap companies hold a middle ground when it comes to risk and reward, which means they are relatively less riskier than small-cap companies but also generate potentially higher returns than large-cap companies. These companies are in their scaling stage, which serves as an interesting opportunity for investors. Mid-cap mutual funds also invest at least 65% of their capital in these companies.

Small-Cap vs. Mid-Cap vs. Large-Cap: Trends In Inflows, Returns & Valuations

To determine whether an index is fairly valued or overvalued, we look at its Price-to-Earnings (P/E) ratio. For this, let’s analyse the indices for large-cap (NIFTY 100), mid-cap (NIFTY Mid Cap 150), and small-cap (NIFTY Small Cap 250).

The P/E ratio is calculated by dividing a company's market price by its earnings per share. It essentially tells us how much investors are willing to pay for every unit of profit a company generates. For example, if a stock has a P/E of 20, it means investors are willing to pay 20 times the company’s earnings per share.

• A higher P/E suggests higher growth expectations, meaning investors are willing to pay more for future potential.
• A lower P/E suggests lower growth expectations or that stocks are trading at a discount.

To assess whether a segment is overvalued or fairly priced, we compare the current P/E with its historical Median P/E. The median P/E is the midpoint of P/E ratios over a historical period. If the current P/E is above the median, it indicates valuations are stretched compared to historical levels. If the current P/E is below the median, stocks may be trading at a discount. 

Let’s look at how large-cap, mid-cap, and small-cap companies compare in terms of valuation in the last 5  years:

Considering P/E is calculated with EPS as a denominator, we must also look at the Median EPS Growth in the last 5 years for these indices. Let’s take a look at these numbers:

In conclusion, large caps appear reasonably priced since their current P/E is below the median P/E and their earnings seem to be growing at a steady pace. 

While for mid-cap funds the valuation looks slightly stretched, considering the current P/E is trading above the median P/E and their earnings are growing at a 2.5x rate (34.5/13.8). 

Similarly, the valuation for small-caps appears to be slightly stretched and their earnings seem to be growing at a much lower rate compared to the P/E. 

How Is The Inflow Across Large-cap, Small-cap & Mid-cap?

Investors' sentiment can also be measured by looking at the inflows in mutual funds. Let’s take a look at mutual funds inflow in different market capitalisations in January 2025 vs 5 years ago in January 2020.

How Does FII & DII Behavior Impact This?

To better understand inflow trends, it’s crucial to look at Foreign Institutional Investors (FIIs) and Domestic Institutional Investors (DIIs) since their capital movement significantly impacts market sentiment.

• FIIs typically favour large-cap stocks due to their liquidity and lower risk profile.
• DIIs generally invest in large and mid-cap stocks, though they have started increasing allocations to small-cap funds in recent years.

Let’s look at the latest data of FII & DII inflow and outflow from January 2025.

FIIs have been aggressively selling, leading to a significant net outflow of ₹87,374 crore in January 2025. DIIs have stepped in with a strong net inflow of ₹86,591 crore, showing their confidence in India's growth story despite global market turbulence.

How Has the Market Capitalization of Large, Mid & Small-Caps Evolved?

Let’s also understand how the market capitalisation of large-cap, small-cap and mid-cap has evolved over the years. For this purpose, let’s measure the market capitalisation as 100. So in December 2015, Out of 100, 71.5% of market capitalization was concentrated with large-cap companies, 15.2% with mid-cap and 13.3% with small-cap.

In December 2024, 59.7% of market capitalisation included large-cap companies, 19.3% mid-cap, and 21% small-cap. Between 2015 and 2024, large-cap companies lost nearly 12% of their market capitalization share, while small and mid-caps gained a combined 11.8%. This signals a fundamental shift in investor preference toward higher-risk, higher-growth stocks

What Do Recent Inflows and Valuations Indicate?

The rise in mid-cap and small-cap mutual fund inflows aligns with the increasing DII participation, as they typically invest in these segments. FIIs pulling out of large caps may explain why large-cap inflows haven't grown as dramatically as small and mid-cap inflows. The rising inflows into small and mid-cap funds also highlight investor confidence and while earnings in these companies have been strong, staying diversified may help manage risks.

Disclaimer:
Mutual Fund investments are subject to market risks, read all scheme related documents carefully before investing. Mutual Funds are non-exchange traded products, and INDmoney is merely acting as mutual fund distributor. All dispute with respect distribution activity, would not have access to exchange investor redressal forum or arbitration mechanism. This is no way to be considered as a recommendation or advise for investment or to avail any advisory services or offer to buy or sell or subscribe for securities.  Past performance are not indicative of the future results.  INDmoney Private Limited 616, Level 6, Suncity Success Tower, Sector 65, Gurugram, 122005, SEBI Stock Broking Registration No: INZ000305337, Trading and Clearing Member of NSE (90267, M70042) and BSE, BSE StarMF (6779), SEBI Depository Participant Reg. No. IN-DP-690-2022, Depository Participant ID: CDSL 12095500. 

Source: Moneycontrol, AMFI, Screener, WhiteOak | Dated: 12 February, 2024