Are Small & Mid Caps Too Expensive? Aditya Khemani Explains

ELI5 / TLDR

A fund manager who runs Invesco’s mid- and small-cap funds in India gets asked the obvious question: with prices this high, isn’t everything overpriced? His answer is that “expensive” only means something next to growth. He’s fine paying 20% over fair value for a company that can grow profits 20% a year for a decade — but won’t touch one that’s 50% overpriced. He also wants to dismantle a popular fear: small and mid caps aren’t risky because they’re small; they’re risky when the underlying business is bad. A defensive small-cap hospital is safer than a giant metal company.

The Full Story

”Expensive” is a meaningless word without growth attached

Aditya Khemani’s whole pitch is that valuation is subjective and most people measure it lazily. The lazy way: look at next year’s price-to-earnings ratio (how many years of profit you’re paying for the stock) and declare the thing cheap or dear. He thinks that’s a trap, because for a real growth company, most of the value lives far out in the future.

“When you look at most most growth stocks 60 70% or maybe more than that valuation value comes from maybe value which is terminal value which occurs beyond next 10 year.”

Translate that: imagine you’re buying an apple orchard. The lazy buyer prices it on this season’s apples. Khemani prices it on the next thirty harvests. If the trees keep yielding more every year, this season’s price tag barely matters.

So his rule of thumb is concrete. Market overall, maybe 20-25% expensive. A company growing earnings at 20% for years — fine, even if you overpay 20%, your eventual return tracks the growth, not the entry premium. A company 40-50% overpriced — a hard no.

“Even if you buy 20% expensive for a company which can grow at 20% for the next 5 7 10 year… your return will not be meaningfully different than the earning growth.”

He anchors the warning with the dot-com crash. IT companies in 2000 had real earnings growth afterward, yet their stocks went nowhere for two decades because the entry price was insane. Growth doesn’t save you if you overpay grotesquely.

The framework: a good jockey on a fast horse

Khemani calls himself a “bottoms-up stock picker” — he builds the portfolio company by company, not by betting on whole sectors. His checklist has a quantitative half and a qualitative half. The quantitative half is unremarkable and he admits it: high earnings growth, high return on capital, good cash conversion, low debt. Every quality investor wants the same things.

The edge, he says, is the qualitative half — the soft stuff you can’t put in a spreadsheet. Two things dominate.

First, the promoter, whom he repeatedly calls the jockey. A mid-cap founder might already be making 400-600 crore in annual profit and could easily get comfortable. Khemani is hunting for the ones who still have “fire in the belly” to go from mid-cap to large-cap. Crucially, he wants a founder who’ll hire and pay real professionals, because the skill that takes a company “from 0 to 1” is not the skill that takes it “from 1 to 10.”

Second, the industry. A great founder in a slow-growth industry eventually hits a ceiling — the company can outrun its sector for a year or two, but the sector’s growth rate always catches up. So he wants founders in industries with long runways. His example: hospitals, where patients keep migrating from small unorganized clinics to big corporate chains.

“Ultimate wealth creation happens when when there’s a ultimate marriage of a good promoter and a business.”

Small and mid cap does not mean risky

This is the part he clearly came to argue. The common belief is that small/mid-cap funds are dangerous because the companies are small. Khemani says the danger is in the business model, not the size.

A “mid cap” in India is just the 101st to 250th largest company — the biggest of them earns 2,500-2,600 crore in profit with thousands of crore in cash and no debt. He reframes it neatly: think of mid caps as smaller large caps, and small caps as smaller mid caps. The genuinely risky zone is the very bottom — companies under 10,000 crore — where he keeps just 5-6% of even his small-cap fund.

“It’s not that small cap or midcap makes a company risky. It’s a business model which makes uh it risky. Even a… large metal company will be risky but even a small cap hospital stock will be less risky.”

His funds lean heavily on defensive sectors — healthcare is 18-20%+ across them — which is why high mid/small-cap weighting doesn’t automatically mean a wild ride.

How the turnaround actually happened

He took over Invesco’s mid-cap fund in November 2023, after a rough 2022-23. The fixes were mechanical and worth noting:

Cut the portfolio down. From ~80 holdings to under 50 (currently 48). A slowing economy demands a sharply positioned book, not a sprawling one — but he caps any single position near 5% to keep volatility in check.
Pick themes that grow regardless of the economy. With macro slowing after mid-2024, he leaned into themes that don’t need a tailwind: quick commerce (a disruptor stealing share from old distribution), hospitals (non-discretionary, structural migration to corporates), and financialization (households shifting from physical assets like gold and property into financial ones).
Dump the hot, cyclical stuff. Industrials and defense had run far ahead of reality — trading at multiples he’d last seen in 2007-08, at peak margins. He cut them. He explicitly refuses to chase momentum.
Balance growth with value. A lesson he stresses: an all-high-PE portfolio soars when growth is in favor and gets “loggered” when the tide turns. So he keeps roughly 60% growth-style, 30-40% value/GARP-style. That balance is why, he claims, the fund did well last year (growth in favor) and this year (growth out of favor).

On liquidity and his own evolution

Small-cap liquidity is a “one-way street” — easy to buy, brutal to sell. His defense is front-loaded: one to two months of analyst work, channel checks on the promoter via ex-employees and competitors, before a stock ever enters. And he keeps bets small at the tiny end.

He also admits his style has shifted. Ten years ago he played investing “like a test match” — buy and hold forever. Now he’s “slightly more agile” (though “not yet a T20”) because disruption cycles have shortened. A company he loves today could get disrupted in two years. His churn runs around 40%, partly forced by India’s twice-yearly reclassification of large/mid/small caps.

Temper your expectations

The closing reality check. Investors anchor to the last five years of fat returns, and they shouldn’t. If GDP grows ~10%, large companies can’t deliver more than ~10-11%, and the broad small/mid-cap index can’t beat ~13-15% over the long haul.

“It is always good for an investor… to think that maybe early teen is what return he will get from the market.”

And within that long-term average sit stretches of nothing — two flat years compensated by a strong third. The market may stay flat another 3-6 months. The people who make money are the ones thinking in 3-5 year blocks; the ones hunting 3-6 month gains won’t.

Key Takeaways

For growth stocks, 60-70%+ of value sits in “terminal value” — earnings beyond year ten — so judging a stock on next year’s P/E ratio is misleadingly simplistic.
Khemani’s valuation rule: paying ~20% over fair value for a 20%-grower is acceptable; 40-50% over is an automatic pass.
Overpaying grossly kills returns even when earnings grow — see year-2000 IT stocks that went nowhere for 20 years despite real growth.
His framework = quantitative screen (high growth, high ROC, good cash conversion, low debt) plus the harder qualitative read of promoter (“jockey”) and industry runway.
The founder who takes a company “0 to 1” usually isn’t the one who takes it “1 to 10” — he looks for founders willing to professionalize and pay for talent.
Risk lives in the business model, not market-cap size: a small-cap hospital can be safer than a large-cap metal company.
India mid cap = the 101st-250th largest companies; the largest mid cap earns 2,500+ crore with net cash. He frames mid caps as “smaller large caps.”
The genuinely volatile zone is sub-10,000-crore small caps — kept to just 5-6% of his small-cap fund by design.
Turnaround levers: cut holdings from ~80 to under 50, cap any position near 5%, exit overheated cyclicals (industrials, defense), keep a 60/40 growth-to-value balance.
Themes chosen to grow without macro support: quick commerce (disruption), hospitals (structural migration), financialization (physical to financial assets).
~80-85% of his recent outperformance came from stock selection, not sector allocation.
Small-cap liquidity is a one-way street; mitigants are heavy pre-purchase research (channel checks) and small position sizes.
Long-run return expectation: ~early teens for small/mid as an index; large caps converge toward GDP growth (~10-11%).

Claude’s Take

This is a competent fund manager giving a clean, internally consistent account of how he works. Nothing here is novel — “buy quality growth at a reasonable price, judge the founder, mind the industry runway” is the standard quality-investing catechism, and he says as much himself about the quantitative side. The value is in how crisply he frames a few ideas: the terminal-value point against lazy P/E judgments, the “smaller large caps” reframing of mid caps, and “risk is the business model not the size.” Those are genuinely useful mental reframes, well articulated.

The BS filter flags the usual things. This is a fund manager on a promotional show, so every answer bends toward “our process is sound and our funds are well-positioned.” His own outperformance numbers are cited approvingly — though to his credit, he repeatedly warns those gaps won’t persist and tells viewers to expect early-teens returns, which is more honest than most. The “60% growth / 40% value is why we win in every regime” claim is the kind of thing that sounds great in hindsight and is hard to verify; balanced portfolios also have a way of being mediocre in both regimes rather than good in both.

Score 7: high signal-to-noise for an investing interview, concrete numbers throughout, and a couple of reframes worth keeping. Not a 9 because the core framework is conventional and the format is inherently a sales pitch.