India’s mid- and smallcap rally continues to attract investors, with several thematic pockets—from defence and power equipment to electronic manufacturing services (EMS), aerospace and AI-linked plays—commanding strong market interest.

But as these stocks scale fresh highs, concerns are growing that momentum and fear of missing out (FOMO) may be running ahead of fundamentals.

The valuation gap is becoming difficult to ignore. While the Nifty 50 is trading at around 21 times earnings, the Nifty Midcap and Smallcap indices are valued at roughly 33x and 32x earnings respectively—a premium of nearly 50-57% over large caps. Several companies in these high-growth themes are now priced for near-perfect execution, leaving little room for disappointment.

In an interaction with Kshitij Anand of ETMarkets, V Srivatsa, Executive Vice President – Equity, UTI AMC, explains why investors need to look beyond the latest hot theme and distinguish genuine earnings potential from FOMO-driven momentum. He also discusses why the risk-reward may increasingly favour large caps, the impact of higher global rates and FII selling, and whether the multi-year run of mid- and smallcaps could be approaching a reversal. Edited Excerpts –

Q) The headline story is interesting: Midcap and smallcap indices are at fresh record highs, but the broader market has been consolidating for weeks. Are we looking at a healthy rotation beneath the surface or growing complacency?

A) On valuations, Bloomberg data shows the Nifty 50 trading at roughly 21x earnings, versus 33x for the Nifty Midcap and 32x for the Nifty Smallcap — a 50-57% premium for mid- and smallcaps over large caps. This premium is among the highest on record. While earnings prospects for mid- and smallcaps have genuinely improved relative to large caps, a premium this large looks unwarranted. The risk-reward favours large caps, and we likely see the multi-year trend of mid- and smallcap outperformance to reverse.

Q) The biggest risk with record highs is that investors confuse momentum with quality. Are we seeing that happen again in parts of the mid- and smallcap universe?

A) We're seeing elevated valuations in select pockets — power equipment, defense-linked mid- and smallcaps, electronic manufacturing services (EMS), aerospace, precision engineering, and pharma CDMOs. These sectors have strong near-term revenue visibility, but they are priced for flawless execution, and the scale-up required is significant enough that perfect execution across every company in these spaces is an unrealistic assumption. What's really driving investor interest here is momentum and fear of missing out (FOMO), more than fundamentals.

Read more: ETMarkets AIF Talk | Aerospace, electronics, CDMO, auto ancillaries: Where Rajesh Kothari sees India’s next growth opportunities

Q) Are we entering another phase where investors are buying anything that is remotely linked to capex, defence, manufacturing, power or AI?

A) Given that AI is one of the hottest global themes, Indian markets are searching for domestic AI proxies, rewarding companies in optic fibre, power systems, and data centre infrastructure. We're seeing similar dynamics in other sectors, such as defense, aerospace and power equipment related space.

Q) Can domestic liquidity permanently offset sustained FII selling, or are we underestimating the influence foreign investors still have on valuations and sentiment?

A) Domestic mutual fund inflows have been exceptionally strong over the past five years, driven by growing awareness and maturity among Indian investors, and this has largely offset heavy FII selling in recent years.

However, if returns underperform alternative investments for a sustained period — say, three years — flows could slow meaningfully.

Healthy, diversified inflows across investor categories matter for the market's long-term health; a slowdown in domestic flows combined with continued FII selling would put pressure on valuations.

Read more: ETMarkets Smart Talk | AI, defence, power: Investors need to be selective as valuations turn expensive, says Aditya Khemani

Q) The market is now watching the US Fed closely. How sensitive is India to the possibility that US rates may remain higher for longer?

A) Global inflation is picking up again, driven by higher energy and food costs (partly linked to the El Niño effect) and weaker demand for US Treasuries.

We think the odds of further rate hikes in the US and other markets are high, and rates are likely to stay elevated for the next three to four quarters.

Higher global rates would also pressure the RBI to raise rates, to maintain an adequate differential with developed-market yields.

Q) US Treasury yields have been moving higher, and historically rising yields tend to trigger a risk-off sentiment by making safe US assets more attractive and tightening global liquidity. How serious a risk is this for Indian equities, particularly expensive mid- and smallcaps?

A) Higher yields make equities relatively less attractive, pushing investors toward other asset classes. AI-related trades have been a key support for global equity markets over the past two years, so they would be most exposed in a broader risk-off move. India would likely be relatively insulated, since Indian markets don't have a significant domestic AI theme — but elevated mid- and smallcap valuations here would still come under pressure.

Q) The IPO pipeline is exploding. Are investors buying businesses—or just buying the hope of listing gains? What is your view on the upcoming NSE IPO?

A) Given stretched mid- and smallap valuations, it's only natural that promoters and owners of potential IPO companies want to cash out. Our investment philosophy centers on long-term investing rather than listing gains — we evaluate every IPO through that lens and invest only when we're convinced of its long-term prospects.

Disclaimer: The views expressed are the author’s own views and not necessarily those of UTI Asset Management Company Limited.

(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)