Smallcap Rally in H2FY26 Depends on FPI Flows and Earnings Recovery, Says Marcellus Expert

The smallcap segment's recovery prospects remain clouded by uncertainty despite recent corrections, with market experts cautioning that multiple factors must align for a sustained turnaround. Krishnan VR, Chief of Quantitative Research at Marcellus, suggests that while valuations have corrected from stretched levels, it remains premature to call a definitive recovery in the smallcap space.

Key Triggers for Smallcap Recovery

VR identifies several critical conditions that must materialize for a broader smallcap rally in H2FY26. The primary catalysts include easing foreign portfolio investor selling pressure, better-than-expected earnings growth, and a supportive macroeconomic environment. He notes that both small and midcap segments entered the year at stretched valuations, making the subsequent correction partially attributable to mean reversion.

Fiscal Stimulus and Economic Outlook

The government has implemented significant fiscal measures to support economic growth, delivering substantial stimulus through policy interventions. VR's analysis reveals that tax and GST cuts totaling approximately ₹4.50 trillion were implemented in CY2025, representing around 1.30% of GDP. This substantial fiscal support, combined with repo rate cuts, is expected to positively impact consumption demand in the second half of FY26.

Sectoral Opportunities and Investment Strategy

Despite near-term uncertainties, VR highlights several structural investment themes with long-term potential. Healthcare services emerge as a particularly attractive sector, driven by rising penetration over the next 10-15 years. This trend is expected to benefit hospitals, diagnostics companies, and health insurance providers. The financialization of household assets presents another compelling opportunity, with companies in insurance, registrar and transfer agents, depositories, and wealth management positioned to capitalize on this structural shift.

VR also identifies potential value opportunities in the IT sector, which has experienced significant pressure from record foreign portfolio investor outflows. The Nifty IT index declined approximately 9.00% from the previous year, potentially creating attractive entry points for investors.

Risk Factors and Market Outlook

Several risk factors could impact market performance and investor returns in the coming period. VR warns that FY27 and FY28 index-level earnings per share growth expectations are set at double-digit levels, making any meaningful downgrades to these projections a potential drag on returns. Export slowdown due to delays in reaching trade agreements with the US poses risks to the current account deficit.

Valuation concerns persist in specific market segments despite the broader correction experienced in 2025. VR specifically highlights auto and defense stocks as areas where investors should remain mindful of valuation risks, as stock prices may have already re-rated in anticipation of future earnings growth.

Supply-Side Dynamics and Market Flow

The market continues to face supply pressure from initial public offerings and promoter selling, which has absorbed significant domestic demand. However, VR notes that supply typically follows fund flows and can indicate market health by preventing rapid valuation increases. Systematic Investment Plan flows have demonstrated resilience through market downturns and have grown despite mediocre returns, potentially signaling a behavioral shift among investors.