Perceived as key beneficiaries of the South Asian nation’s 8%-plus economic growth, shares of smaller firms are seen staging a comeback after a selloff that’s pushed down the Nifty Smallcap 250 Index almost 10% since Feb. 27. That was the day the Securities and Exchange Board of India directed mutual funds to take steps to shield investors from the speculative froth in small- and mid-cap stocks.

The rout follows a stellar run that saw the small-cap gauge add over $230 billion in value since March last year, driven by robust earnings and relentless flows from India’s army of retail investors. While valuations are still rich, buyers with a sense of history say episodes of tumult like the current one are common in a bull market and tend to spur a shift to quality.

“It is without doubt an opportunity to purchase high-quality, well-managed companies at more attractive prices,” said Mike Sell, head of global emerging equities at UK-based Alquity Investment Management Ltd. “Nothing fundamentally has changed, while recent corporate commentary paints a stronger picture than is perhaps widely appreciated.”

Morgan Stanley earlier this week said that India’s current economic expansion resembles the boom period of the mid-2000s, when growth averaged more than 8%. During that era, a small-cap index managed by the BSE Ltd. skyrocketed over 1,200% — an ascent that saw several bouts of shortlived corrections.

The National Stock Exchange’s small-cap measure was introduced much later. It has seen two corrections — of 27% and 14% — since March 2020, only to bounce back strongly in each instance over the next six to 12 months.

“This shakeout is definitely welcome,” said Deven Choksey, managing director of DRChoksey FinServ Pvt. in Mumbai. “Investors won’t mind this correction.”

To be sure, valuations remain elevated despite the drawdown. The small-cap gauge is trading at almost 21 times its one-year forward earnings versus a five-year mean of 18 times. That’s prompting some strategists including those at Goldman Sachs Group Inc. to recommend a switch to India’s biggest companies. 

Small-cap stocks “appear crowded with domestic ownership at multiyear highs,” the US bank said in a note Friday. “We continue to retain a preference toward large caps and expect further rotation to quality pockets this year.”

Bulls say the blowout returns in smaller companies stem from robust corporate profit growth in recent years. Earnings of members in NSE’s smallcap gauge have more than doubled since 2022, outpacing the 40% jump in the index during the period, data compiled by Bloomberg show.

As stocks extended losses this week, domestic and foreign funds bought into the declines. Flush with money, local funds injected a record $1.1 billion into shares on Wednesday, when small- and mid-cap indexes endured their worst selloff in more than two years.

Read more: Global Funds Catch Craze for India’s Minnows in Hunt for Winners

“Volatility of the sort we’ve seen this week provides exceptional opportunities to investors,” said Andrei Stetsenko, partner and portfolio manager at New York-based Farley Capital LP. “I would not be surprised if other foreign funds present in Indian mid- and small-caps were, like my firm, significant net buyers in recent days.”

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