A month later, there was a reversal in sentiments. The Nifty 50 index fell to a three-month low below 16,800 last week of November before recovering. Subsequent rallies, however, were subdued.

In contrast, the Nifty Small cap 250 index started CY 2021 around 6,100 and escalated at an impressive pace over the coming period. What was notable was that the index had notched impressive gains in the earlier year, piling up 25% in CY 2020. The resilience of the index was significant as it had witnessed a bloodbath in the aftermath of covid-19 related national lockdown in March 2020. It had tanked to near the 2,800 level in the last week of March 2020. Other indices, too, had suffered severe rout.

The spurt of the small-cap index from these depths was impressive. Attractive valuations coupled with extremely good earnings potential triggered good buying support in counters constituting the index.

With a near 59% spurt over year on year to 17 December 2021, the small-cap index has comfortably beaten the returns delivered by major market cap-based indices. The Nifty 50 index gained around 23.60% and the Nifty Midcap 150 index jumped about 44%.

Small-cap stocks are normally considered to be highly volatile counters or high beta stocks, offering potentially higher risks as well as rewards. This makes investing in small-cap stocks more risky than investing in large- or mid-cap stocks as these counters face extreme stress in times of market turmoil. The freefall in NIFTY Small Cap 250 index in first quarter of CY 2020 reflects this quite clearly. However, small-cap stocks also have the potential of providing extremely high returns over the long term if the investors identify the companies that would transition from small-cap to mid and large-cap stocks over the years.

Therefore, one should consider investing in small-cap shares keeping in mind that an onslaught of volatility could hurt such investments in short term. However, for investors with a longer-term horizon of 5-10 years, such counters have proven to be highly effective wealth generators. Given the high risk-reward nature of investments made in small-cap stocks, they should ideally form only a small part of your overall investment portfolio. Remember that most large-cap companies started out as small businesses. Individual investors who were able to participate in their growth have managed to build substantial wealth over the years.

Compared to larger stocks, small-cap investing offers greater risks but also provides increased return potential. Therefore, investors should ask themselves what their risk tolerance and time horizon are. Younger investors who plan to hold stocks for decades are generally better suited for small-cap investing than retirees living off dividend income. Given the larger picture, holding few small-cap stocks is a good idea for most investors. Sales growth is particularly important for small-cap stocks because younger companies should be able to deliver higher revenue growth than larger, more mature companies.

Riding on the recovery in economic growth, the allure of small caps coincided with the acceleration of local economic growth. Yet their appeal remained intact. The Nifty 50 index slipped well below the all-time high of 18,600 in the first three weeks of December 2021, witnessing a slide of nearly 1500 points from the top while the Nifty Small-cap 250 index stayed broadly supported around 9000 mark despite selling pressure.

The current rally in small caps marks the continuation of a rebound before the covid-19 crisis hit the market. The index had topped out around 7,500 in January 2018 but continued to slide throughout the next two years. The index cracked by 28% in CY 2018 and declined 9.5% in CY 2019.

Apart from broad macroeconomic worries, a critical policy shift played a major role in this dismal outing for small caps. On 6 October 2017, the Securities and Exchange Board of India (Sebi) defined large, mid, and small caps to ensure uniformity for investment by equity mutual funds.

Sebi directed the Association of Mutual Funds of India (AMFI) to prepare a list of stocks in accordance with the new guideline, with a revision every six months. The change triggered a sustained flurry of selling in small caps even as the Nifty 50 ended with a gain of 3% in CY2018 and jumped by 12% in CY2019.

Despite the change in market dynamics in CY 2020, following the onset of covid-19, small caps bounced back, racing past the gains in large and mid-caps, as they had bottomed out.

The strength of the local small-cap segment is also visible in other global indices. The MSCI India Small Cap Index, designed to measure the performance of the small-cap segment of the Indian market has been on a roll in recent times. With 259 constituents, the index represents about 14% of the free float-adjusted market capitalization of the India equity universe. Over a long term, the index has been a terrific performer with a year-to-date return of around 45% as on 30 November 2021, comfortably beating the MSCI Emerging Markets Small Cap index, which clocked a gain of around 14.40% during the same time.

The broad MSCI ACWI Investable Market Index (IMI), which captures large, mid and small cap representation across 23 Developed Markets, has also returned just around 14% year to date as on 30 November 2021. The MSCI India Small Cap index outperformed both these global indices over a five- and 10-year period as well.

A look the behaviour of overseas investors towards the top 50 gainers in the small-cap index over last one year indicates that foreign portfolio investors (FPIs) have been comfortable in increasing their holding in majority of these counters. A total of 15 stocks have seen FIIs decrease their holdings over the last one year but the change is less than 1% for nine counters, effectively ensuring that for almost all stocks in the list, overseas investors have been either increasing their stakes or keeping it steady.

The sales performance has been impressive too, with only three companies in the list recording a decline in TTM ended September 2021 net sales compared with the previous TTM.

The Nifty Small-cap 250 represents the balance 250 companies (companies ranked 251-500) from Nifty 500. This index, intending to measure the performance of small market cap companies, is computed using the free-float market capitalization method. The level of the index reflects the total free float market value of all the stocks in the index relative to a particular base market capitalization value.

The Nifty Small-cap 250 is used for a variety of purposes such as benchmarking fund portfolios, launching of index funds, ETFs, and structured products. For inclusion in the Nifty Small-cap 250 index, companies must be part of Nifty 500, but should not be in the Nifty 100 and Nifty Mid-cap 150 indices. The eligibility criteria for newly listed security are checked based on a three-month period instead of a six-month period.

The small-cap index is re-balanced on a semi-annual basis. The cut-off date is January 31 and July 31 of each year. The average data for six months ending the cut-off date is considered. Four weeks prior notice is given to the market from the date of change. A professional team manages all NSE indices. There is a three-tier governance structure comprising the board of Directors of NSE Indices, the Index Advisory Committee (Equity) and the Index Maintenance Sub-Committee.

For the Indian economy, the current recovery is spearheaded by an uptick in private investment through November-December alongside a turnaround in bank credit offtake and high capex from the government sector (Centre and states). In conjunction, the employment situation has brightened. Besides, the seven-day moving average of daily covid-19 cases plummeted below 9,000 by the close of November.

There is plenty of traction on the external front too for the domestic businesses. India's merchandise exports in November were US$30.04 billion compared with US$23.62 billion in the year-ago period, exhibiting a growth of 27.16%. Merchandise imports in November came in at US$52.94 billion, an increase of 56.58% over imports of US$33.81 billion in the same month last year. Hence, India's trade deficit widened to US$22.91 billion as against U$10.19 billion in November 2020.

Exports for the April-November period were up 51% to US$263.57 billion as against US$174.16 billion during the same period last year, while imports rose 74.8% to US$384.34 billion. Non-petroleum and non-gems and jewellery exports in November 2021 stood at US$23.68 billion, a growth of 22.26% over a year ago and indicating the durability of the spurt in external demand. During April to October, domestic industrial production advanced 20% from the same period last year.

India's central bank is optimistic of the economic outlook. In its December monthly update, it states that the ongoing domestic economic revival is driven by a confluence of factors: release of pent-up demand, government's push for capital expenditure, robust external demand, and normal monsoon. Faster resumption of contact-intensive services and speedy restoration of consumer confidence brightens near-term prospects.

According to TransUnion Cibil MSME Pulse report for June 2021, the economic recovery in the country is well entrenched at the ground level. The Emergency Credit Line Guarantee Scheme or ECLGS and other interventions for the MSME sector have led to higher loan amount disbursed to MSME segment in FY 2021 than earlier years. In FY 2021, the country disbursed loans worth Rs 9.5 lakh crore to MSME sector; higher than preceding year of Rs 6.8 lakh crore in FY 2020. This sharp jump in MSME lending for FY 2021 was supported by Atmanirbhar Bharat scheme of ECLGS which provided 100% credit guarantee to lenders. Unlocks in June 2021 have led to a sharp bounce back in credit demand (measured as credit enquiries) by MSMEs, which was dampened by the 2nd wave after a strong 4th quarter of FY'21. After the initial drop in commercial credit enquries by 76% due to the 1st wave, they recovered fast with ECLGS and have since sustained close to pre-COVID levels. March2021 commercial credit enquiries were 32% over pre-COVID levels; this strong momentum was impacted by 2nd wave, but June 2021 saw a sharp recovery back to pre-COVID levels. MSME credit outstanding has grown by 6.6% YoY in March'21, with Micro segment growing the fastest at 7.4%. Strong rebound in credit demand, accompanied by equally strong credit supply and ECLGS support, has led to growth in the credit outstanding amount of MSME sector to ‘20.21 lakh crores, with a YoY growth rate of 6.6%. Micro segment has grown fastest at 7.4%, followed by Small segment at 6.8% and Medium segment at 5.8%.

Such a scenario is likely to benefit the small cap players over the coming months. The strength in rural demand is also a supportive factor for these companies given their close linkage with the GDP. Economic Survey 2021 noted that Rural demand has remained resilient empowered by the government's thrust on the rural economy and infrastructure in previous years, through a bouquet of reforms for both farm and non-farm sectors. There has been re-energised focus in the last six years on rural roads by extension to smaller villages, rural housing and sanitation, provision of basic amenities under various Government Schemes and creation of durable assets through MGNREGS. These measures have been reinforced by rural digitalisation and financial inclusion drives which also aided in smooth implementation of demand push measures during COVID-19. Initiatives to spur skill development, entrepreneurship, Self Help Groups and livelihoods have further empowered the rural economy to combat the COVID-19 induced vagaries.

Outlook

The benchmark equity indices fell in first three weeks of December as worries posed by Omicron strain of Covid-19 hurt the sentiments. Also troubling was the visible shift in the ultra-easy undertone of global monetary policy. The US Federal Open Market Committee on decided to keep the target range for the federal funds rate at 0 to 0.25%. With inflation having exceeded 2%, the comfort level, for some time, the committee felt appropriate to maintain the target range until labour market conditions reached levels consistent with the assessments of maximum employment.

Against this backdrop, the Fed committee decided to reduce the monthly pace of its net asset purchases by US$20 billion for Treasury securities and US$10 billion for agency mortgage-backed securities. Beginning January, the Fed will increase its holdings of Treasury securities by at least US$40 billion per month and of agency mortgage-backed securities by at least US$20 billion per month. The committee judged that these levels of reductions in the pace of net asset purchases will likely be appropriate each month but is prepared to adjust the pace of purchases if warranted by changes in the economic outlook.

A similar approach was reflected in the European Central Bank's (ECB) monetary policy statement. It will roll back its Euro 1.85 trillion Pandemic Emergency Purchase Program (PEPP). The Bank of England hiked interest rates for the first time since the onset of the pandemic, increasing its main interest rate to 0.25% from its historic low of 0.1%.

Though the Reserve Bank of India (RBI) continued to maintain its interest rates at a multi-year low, it, however, disclosed its intention to move towards higher rates in its monetary policy review in December 2021 by raising the amount it absorbs from banks through the 14-day variable reverse repo (VRRR) auction.

Going forward, the RBI noted, the emergence of the Omicron strain has heightened the uncertainty in the global macroeconomic environment, accelerating risks to global trade with resumption of travel restrictions, quarantine rules at major ports and airports. The ongoing supply-side constraints are likely to keep input prices and freight rates at elevated levels and could act as a drag on overall exports.

The slide in Nifty Small-cap 250 index in the two years before the onset of covid-19 factored in the moderation in economic growth. Reeling under the national level lockdown, the index displayed the close connect with national output trends. The GDP has bottomed out from its decade low mark and credit flow is picking up. The Credit Market Indicator (CMI), a comprehensive measure of retail lending health trends by TransUnion Cibil, noted in its December 2021 update that India's retail lending market is poised for strong growth owing to timely policy interventions and better adaptability by lenders. Credit demand has recovered this year as economic activity gained momentum and inquiry volumes increased by 54% between February 2021 and October 2021 as against 12% decline during same period in the previous year.

The next orbit of equities market will likely see a continuation of the domestic economic cycle. The pent-up demand and recovery in consumer confidence will likely support the sentiments for local equities in next few months. Challenges posed by the new covid-19 variant as well as worries over local inflationary trends could, however, curb enthusiasm. Global markets turned volatile in December 2021 on the onset of the spread of Omicron.

Sticky inflation could prove to be challenging for small-cap players as it could hurt aggregate demand. India's Consumer Price Index (CPI) recorded a rise of 4.91% year-on-year in November on the back of a rise in vegetable prices. Core inflation, which is the non-food non-fuel component of the CPI basket, stood at 6.1% against 5.8% seen in the month before. Inflation in the food basket in November rose to 1.87% from 0.85% a month ago.