Greetings from Team Carnelian!

We hope you and your family had a wonderful year. In last year’s letter, we drew a cricket analogy – likening the market to an overcast day where a batsman’s priority is to protect his wicket until conditions improve. Indeed, 2025 proved to be such an overcast year in market terms, demanding a disciplined and defensive stance. As we reflect on the year gone by, this prudent approach seems vindicated, and it offers valuable insights as we build for the future. But just as the best innings begin with resilience in tough conditions, we believe the tide is turning now. With the skies beginning to clear, it may finally be time to rotate the strike and accelerate. From a market perspective, 2026 appears positioned for a business-cycle turn and improving earnings momentum.

Year in review for the Markets: 2025 – A test of patience in turbulent times

On the surface, market returns didn’t appear alarming – the Nifty 50 gained about 10.5% and the BSE 500 was up roughly 8% in calendar year 2025. However, we all know how these headlines conceal a very weak market breadth, as the rally was narrow and concentrated. Many stocks, especially in the mid- and small-cap space, corrected despite index gains.

Year	Nifty 50 Return (%)	Nifty Midcap 150 Return (%)	Nifty Small cap 250 Return (%)
2024	8.8%	23.1%	25.6%
2025	10.5%	5.4%	-6.0%

Source: Bloomberg

This weak breadth underscores how tough the year was for most investors outside a handful of large-cap names. In fact, nearly 69% of all listed companies (market cap > ₹100 cr) posted negative returns in 2025, a stark reversal from only 28% stocks declining in 2024. Clearly, 2025’s “rally” was very narrow – it paid to be in a few large caps, while the average stocks struggled.

Category	Total number of stocks	Number of stocks down	% of stocks down	Median down
Large Caps (Nifty 50)	50	18	36%	10%
Mid-Caps (Midcap 150)	150	82	55%	19%
Small Caps (Small Cap 250)	250	164	66%	20%

The roots of the challenging earnings environment in 2025 can be traced back to the tightening liquidity and pre-election spending constraints that began in early 2024.

Earnings – Earnings momentum weakened through the year. Corporate earnings growth came in muted – Nifty 50 companies’ earnings for CY25/FY26 are estimated to have grown only ~3% year-on-year.

Valuations – Valuations were stretched at the start of the year, with the Nifty 50 trading at a peak of ~25x FY26E earnings. Since then, multiples have corrected to around 20× on trailing 12 months, bringing valuations closer to historical norms. In contrast, mid- and small-cap segments have seen a much sharper valuation correction over the same period.

Year in review for Carnelian – 2025: Navigating with discipline and differentiation

2025 was a strong year for Carnelian, where differentiated strategy and bottom-up stock selection drove meaningful outperformance in select portfolios.

• Compounder Strategy stood out as the top performer, delivering 19% return and generating 11% alpha. The fund’s focus on consistent earnings compounding and high-quality growth businesses paid off well. Key contributors included Laurus Labs, AB Capital, Paytm, and Maruti, all of which benefited from strong business execution and favourable structural tailwinds.
• Bharat Amritkaal, our flexi-cap strategy, delivered 7% return, broadly in line with market benchmarks. The portfolio maintained a balanced positioning through market rotations, prioritizing quality and capital protection.
• Shift Strategy, our mid- and small-cap strategy focused on India’s long-term manufacturing and technology opportunity (with zero exposure to BFSI which has been the main contributor to indices gains), faced a challenging environment delivering negative return of 3.5% — particularly due to IT underperformance. While this led to underperformance versus the BSE 500, the strategy outperformed the BSE Small Cap Index by ~2%.

While dispersion in market performance was high, our continued emphasis on research-driven investing and alignment with structural themes allowed us to navigate the year with resilience and build a strong base for 2026.

2026 Outlook: Business cycle to turn

While all the above is now history — and markets are forward looking, aren’t they? — let us shift focus to how we see FY26 shaping up.

• Pro-growth Fiscal Policy – Tax cuts to drive consumption and growth: The FY26 Budget raised income tax exemption limits and reduced rates for middle-income earners, increasing disposable income and improving household spending capacity. In tandem, broad-based GST cuts on consumer durables and everyday goods reduced prices meaningfully. These measures are expected to boost discretionary and essential consumption, support higher capacity utilization for businesses, and ultimately contribute to GDP growth through a stronger consumption multiplier.

• Monetary easing – Lower rates and credit stimulating measures by RBI: With the appointment of a new RBI Governor, monetary policy has clearly pivoted toward supporting credit growth and economic momentum. The RBI has cut repo rates by 125 bps to ~5.25% and backed this with lending-supportive measures, including reduced risk weights on loans, durable liquidity infusion through open market operations, deferment of tighter liquidity coverage ratio (LCR) norms, and permission for banks to finance mergers and large corporate activity. Together, these steps have lowered the cost of capital across the system, improving borrowing affordability for consumers and businesses, and should support a pickup in credit growth and overall economic activity through 2026.

• FII selling likely to reverse in 2026: Foreign institutional investors have been heavy sellers in Indian equities over the past two years, initially due to rising U.S. interest rates and, more recently, due to capital rotation toward relatively undervalued China. As a result, FIIs net sold nearly USD 18 billion of Indian equities in 2025 — the largest annual outflow on record — pushing foreign ownership to a ~15-year low of ~17%. With India’s EM overweight now meaningfully reduced and U.S. interest rates expected to trend lower, the risk–reward for foreign investors is turning more favourable, setting the stage for a potential reversal in FII flows in 2026.

• Structural Tailwinds Intact – Foundation for Long-Term Growth: India continues to benefit from powerful structural drivers: production-linked incentive (PLI) schemes, simplified GST, and ongoing labour reforms are steadily improving the ease of doing business. The global shift toward a “China+1” strategy is bringing manufacturing and supply chains to India, aided by large-scale infrastructure investments in roads, rail, and digital networks. Combined with a young, aspirational population and rapid digital adoption, these forces are expanding India’s productive capacity and positioning it as a key engine of global growth over the coming decade.

What will eventually lead the rally from here?

Having outlined the positives, let’s now focus on the triggers for a turnaround in the markets. With multiple catalysts aligning — some already unfolding and others nearing resolution — we believe these shifts could move a phase of caution to phase of opportunity.

• A bilateral U.S.–India trade deal could remove tariff uncertainty and reignite export growth in sectors like pharma, textiles, and electronics.
• As expansionary fiscal and monetary policies gain traction, a turning business cycle is likely to position domestic sectors as leaders of the next earnings upcycle.
• A cooling in the global AI trade may drive capital rotation toward markets like India that offer stronger fundamentals and more reasonable valuations.

Key Investment Themes for 2026

As macro headwinds fade and policy support strengthens, we expect the investment landscape in 2026 to gradually transition from phase of caution to phase of opportunity.

• Business cycle turnaround: As business cycle turns, early beneficiaries could be domestic sectors like banking, autos (especially commercial vehicles), and consumer-linked businesses to rebound first as demand and credit growth improves. In contrast, sectors that led in the previous upcycle (e.g. capital goods and other investment-driven themes) may take a back seat or see slower momentum initially as the focus shifts to reviving consumption-led growth.

• Currency tailwinds for exporters: A gradually depreciating INR can act as a tailwind for export-oriented industries. Sectors such as pharmaceuticals, CDMO (also the beneficiaries of the China+1 shift), and IT services – which generate significant revenue overseas – stand to benefit from a weaker rupee that improves their global competitiveness and margins.

Risks We Are Monitoring Closely

While the setup for 2026 appears increasingly constructive, several external and domestic risks warrant vigilance. Our optimism remains informed — not blind — and we continue to track the following developments closely:

• Global slowdown potential: The U.S. economy could weaken more than expected. High interest rates and any new tariff impacts may eventually tip the U.S. into a sharper slowdown, which would have knock-on effects on global and Indian growth. A soft landing is the hope, but a harder landing in the U.S. (or other major economies) cannot be ruled out under adverse policy outcomes.

• Trade and tariff uncertainties: Clarity on pending tariff policies (particularly in U.S.–China and U.S.–India trade relations) is still absent, and trade measures have become more a function of geopolitics than economics. India’s trade tensions with the U.S. remain elevated heading into 2026, and any aggressive tariff actions could disrupt global supply chains.
  
• Geopolitical tensions: Rising geopolitical tensions across regions — including ongoing conflicts in Eastern Europe, South America, and the Middle East, as well as potential instability in the Taiwan Strait — pose risks to global supply chains, energy markets, and investor confidence. While this is not our base case, any meaningful escalation could trigger risk-off sentiment and increased market volatility.

Conclusion – From a year of Caution to a year of Opportunity

Phases like 2025 are a recurring feature of market cycles, where returns compress, breadth narrows, and avoiding mistakes becomes important. 2022 was also one such year, when the Nifty 50 delivered a modest 4.3% return, while the Nifty Smallcap Index declined 13.8%. However, this was followed by a strong recovery over the next 18 months, with the Nifty 50 and Nifty Smallcap Index delivering returns of 27.6% and 84.2%, respectively. We believe current market sentiment resembles that of 2022, and 2026 could emerge as an inflection year for investors as earnings growth accelerates, FII participation returns, and mean reversion plays out.

Market returns in 2026 are likely to track earnings growth, which we expect to be in the 12–15% range. Any valuation re-rating will depend on the direction and strength of FII flows. If positive FII inflows materialise — which we strongly expect — markets could see an additional 3–5% re-rating, potentially translating into overall returns of 15–20%. However, our base case remains earnings-led growth, with upside from re-rating — a potential magic event. We also believe mid- and small-cap stocks could stage a strong comeback, similar to the post-2022 period.

As with every market cycle, true alpha will be generated through disciplined stock selection — identifying the right companies in the right sectors while avoiding laggards. Generating alpha requires deep bottom-up research and a focus on resilient, growing businesses within what is currently a narrow pool of fundamentally strong opportunities.

As we step into this phase, we remain committed to our core principles: protecting capital, participating in opportunity, and compounding wealth through conviction in quality. We thank you for your continued trust and look forward to navigating the year ahead together—calmly, carefully, and confidently.