That, according to Carnelian, is why investors should not equate size with safety or growth. The companies that could become tomorrow’s large caps are often still found outside the large-cap index.

The advantage of smallcaps is not only that the median company has grown faster. It is also that the segment offers a much larger pool of high-growth businesses.

Between FY16 and FY26, 279 smallcaps compounded profits at more than 20% annually, compared with only 13 largecaps. Even between FY22 and FY26, when the median smallcap grew broadly in line with the median largecap, 397 smallcaps compounded profits at more than 20% annually.

The difference is even sharper among the strongest performers. “This is the stock picker’s market,” Carnelian said.

The market returns underline the dispersion. Since April 2023, 354 smallcaps have more than tripled, while 171 have delivered negative returns.

The gap between the top and bottom deciles of smallcaps was 820 percentage points, nearly five times wider than in large caps. That makes segment level investing less useful and company-level selection more important.

Carnelian acknowledges that the smallcap rally has not been driven entirely by earnings. 5 times.

The largecap multiple has remained around 21 times. Largecaps generated earnings growth but underwent a de-rating, limiting investor returns.

Smallcap returns, by contrast, were driven to a greater extent by valuation expansion. That creates a clear risk: smallcaps no longer look inexpensive on current earnings, and the investment case now depends on future growth.

Carnelian cited Laurus Labs as an example of why current valuations can sometimes be misleading. The stock traded at a P/E of 78 times in FY24, but earnings almost tripled over the next two years while the stock rose fourfold.

The broader argument is that a high multiple can be justified if earnings compound rapidly enough. 7% for largecaps.

If those estimates are achieved, Carnelian believes the smallcap valuation premium will largely disappear by FY28. Carnelian also cautions investors against using the 21-times largecap PE as evidence that the entire largecap universe offers valuation comfort.

Around 60% of largecap FY27 profits come from financials, global commodities and IT. These sectors trade at relatively low multiples, ranging from 13 to 19 times earnings, helping pull down the headline largecap valuation.

However, the typical domestic largecap franchise trades at a far higher valuation. Among 84 largecaps with earnings estimates, 46 are domestic, non-financial companies, trading at a median 42 times FY27 earnings.

Of these, 44 trade above 30 times earnings and 21 trade above 50 times. In Carnelian’s view, investors shifting to large caps for valuation comfort may simply be exchanging small-cap growth for either cheap global cyclicals or expensive domestic franchises.

Carnelian’s case does not ignore the risks. Smallcaps tend to fall harder during market corrections and can take years to rec over.

Since 2005, the Nifty Smallcap 250 has outperformed the Nifty 50 in only about half of all rolling five-year periods. Small companies also carry higher company-specific risk, weaker balance sheets and lower capacity to absorb economic shocks.

Lower liquidity and thinner free floats can amplify price movements, while popular narratives can lead investors to pay for growth before it materialises. For Khemani, the key risk is not simply owning a small company.

It is owning a poor business or one with weak management. Carnelian’s framework focuses on five factors: a large and growing opportunity, a durable competitive moat, promoters capable of scaling the business, efficient capital allocation and strong governance.

The firm said it plans to launch the Carnelian Small Cap Mutual Fund, marking its entry into the category.

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