Year-End Reflections And 2025 Outlook: The Role of Small Caps/Mid Caps And Their Potential In Wealth Creation

It is true that the small-cap basket has performed exceptionally well in recent years; the Smallcap 100 index has a five-year compound annual growth rate (CAGR) of over 28%. The nicest thing to mention, though, is that in only one year, the S&P BSE SMALLCAP and S&P BSE MIDCAP indices have both beaten the Nifty and Sensex.

As 2024 draws to a close, the Nifty has gained 10.8% so far, the S&P BSE SENSEX has climbed 10%, the S&P BSE SMALLCAP index has gained 30.7%, and the S&P BSE MIDCAP has picked up 28.29%. Following such a robust surge, the small-cap/mid-cap basket has outperformed the major benchmark indices, as these numbers plainly illustrate.

Investors can expect volatility in 2025 due to execution delays, liquidity movements, and general market sentiment while investigating this market. Because this type of trading frequently sees unpredictable price fluctuations, it's important to stay mindful of this and take advantage of the volatility by spreading out your investments. We learnt that small-cap investment would need a very selective strategy from an interview with Pawan Bharaddia, co-founder and CIO of Equitree Capital. Investors should choose companies with excellent growth visibility and concentrate on a ground-up examination.

Here are some discussions from Goodreturns's interview with Pawan Bharaddia, co-founder and chief information officer at Equitree Capital.

1. The small-cap basket has shown remarkable performance over the past few years. What is your outlook for small-cap and mid-cap funds in 2025? Do you believe they will continue to demonstrate resilience?

The small-cap basket has indeed delivered exceptional performance over recent years, with the Smallcap 100 index achieving a five-year CAGR of approximately 28%. Following such a strong rally, it's natural to expect some degree of correction or consolidation in the broader markets. From here on, small-cap investing will require a highly selective approach. Investors should focus on a ground-up analysis and target businesses with strong growth visibility.

2. With mid and small-caps projected to outperform large-caps in the coming year, what key factors do you think will fuel this growth, and what should investors keep in mind when navigating these segments?

Two clear themes are playing out for small caps: increasing market share in global merchandise exports and import substitution, both of which are driving domestic manufacturing and engineering sectors. India currently holds around a 2% share in global manufacturing exports figure that's rising on the back of EU+1, China+1, and Bangladesh+1 strategies. This shift helps Indian companies gain incremental market share. Additionally, with the government's emphasis on "Make in India," many products once imported are now being manufactured locally. Given these tailwinds in the manufacturing space, the SMID bucket offers far more opportunities compared to large-caps, which tend to dominate FMCG, healthcare, IT, and banking.

While exploring this segment, investors need to be prepared for volatility stemming from execution delays, liquidity flows, and overall market sentiment. This genre of investing often experiences erratic price swings, so it's crucial to remain aware of this and use the volatility to your advantage through staggered investing.

3. How would you describe your overall investment strategy, and what makes it unique in today's market environment?

At Equitree, we take a very business-like approach to investing. We're sector-agnostic and only invest in companies whose business models we understand well. We prefer not to take early-stage risks; instead, we look to buy into businesses that have existed for a considerable length of time and are at an inflexion point for high growth.

What's unique at Equitree is our patient, long-term capital and our ability to identify high-growth businesses well ahead of time. Similar to a private equity fund, we aim to buy meaningful minority stakes in the companies we invest in and then hold on as long as the growth continues-allowing compounding to work over extended periods. Our average holding period is around five years, and more than half of our portfolio has been with us for over seven years!

4. What filters do you rely on when identifying promising stocks for your portfolio?

Over the last 12 years at Equitree, we've developed our own proprietary framework for evaluating investment opportunities. First, we generally look for companies with a minimum of two decades of operating history. Beyond that, we pay close attention to cash flow generation and prefer businesses that can generate and redeploy cash to fuel consistent growth, reducing reliance on external capital. Needless to say, we also use various quantitative filters-like PEG, ROCE, and Debt-Equity ratios-as part of our initial screening process.

5. Can you highlight some of your top bets, lessons from past mistakes, and advice specifically tailored for Gen Z investors?

One of our top bets has been a company in the Agri-equipment space, which has delivered around 40x returns since our first buy-in 2017-and we continue to double down on it.

Over the past 12 years, the biggest lesson we've learned is how critical it is to distinguish between systematic and unsystematic risks. This distinction is especially vital when deciding what action to take if a stock price drops 40-50% from the buying price. For example, in the investment mentioned above, we've held that company for seven years and have seen three separate instances of a 50%+ price correction, but once the thesis plays out, it truly rewards you in the long run.

My advice for Gen Z investors: Don't let the daily adrenaline rush of trading overshadow your long-term wealth creation journey. Patience is absolutely key to letting compounding work its magic.

6. Could you share insights into your portfolio allocation by sector, and elaborate on Equitree's affinity for small-cap investments?

At Equitree, we are largely sector-agnostic, although we tend to have a bias toward manufacturing, engineering, and infrastructure ancillaries. Our current portfolio includes companies across agriculture, textiles, auto ancillaries, consumer durables, and infrastructure.

Our general affinity is for assessing a company's intrinsic value by taking a justified amount of risk. This approach has worked well for two main reasons: first, these companies often experience high-growth cycles, offering opportunities for disproportionate returns; and second, they tend to be under-researched and under-invested. By identifying them early, we capture what we call a "discovery premium" as the business scales up and draws attention from institutional investors. Leveraging these factors has enabled us to unlock substantial value in our investments.

7. What are your budget expectations?

Lately, most policy decisions have been made outside the budget. Over the past few years, the budget itself has primarily served as a statement of account, and we believe this trend is likely to continue. We expect the government to maintain its focus on infrastructure spending while striking a careful balance on fiscal deficit in the upcoming budget as well.