Making the Case for Small Caps

By Scott Welch, CIMA®, Chief Investment Officer & Partner

Reviewed by Carter Mecham, CMA®, IACCP®

Let’s face it. If you are a believer in the size factor (i.e., smaller cap stocks), like we are, it has been a pretty rough road the past few years.

The market has been so dominated by US large cap growth stocks that it has been hard to defend our continuing recommendation to allocate to small caps.

We see this clearly at the broad asset class level.

Source: Ycharts, 5-year data through November 24, 2024. You cannot invest in an index and past performance is no guarantee of future results.

And even within large cap stocks, the mega-cap tech stocks have obliterated the rest of the S&P 500 index.

Source: Yardeni Research, as of November 22, 2024. You cannot invest in an index and past performance is no guarantee of future results.

The result is a historically wide valuation dispersion between large and small/mid cap stocks. You need to go back to the “dot com” tech bubble of the early 2000s to see valuation differentials as wide as they are today.

Source for both charts: Yardeni Research, as of November 22, 2024. You cannot invest in an index and past performance is no guarantee of future results.

Source: BNP Paribas Asset Management, as of November 13, 2024. You cannot invest in an index and past performance is no guarantee of future results.

Time horizons matter, however. If we go back to 1995, we see similar cumulative performances between large and small cap stocks, with small caps outperforming significantly in the almost 20-year period between 2000 and 2019.

Source: Ycharts, data through November 24, 2024. You cannot invest in an index and past performance is no guarantee of future results.

Another issue to pay attention to is quality, which we can illustrate by comparing the historical performances of the two primary US small cap indexes, the Russell 2000 and the S&P 600. 

The S&P 600 is considered to be a higher quality index because it contains fewer firms with negative earnings (which make up roughly 40% of the Russell 2000 index).

We see that during periods of economic recovery and/or a broader equity bull market, lower quality companies can outperform but, over full market cycles, quality matters.

Source: Ycharts, data through November 24, 2024. You cannot invest in an index and past performance is no guarantee of future results.

What About Non-US Stocks?

It certainly is true over the past several years that US stocks have outperformed non-US stocks, causing many investors to dramatically overweight US stocks relative to a global equity benchmark. 

The MSCI All-World index, for example, is roughly 63% US and 37% non-US stocks. Most US investors come nowhere near that level of non-US allocation.

Source: Ycharts, 10-year data through November 24, 2024. You cannot invest in an index and past performance is no guarantee of future results.

But what many, if not most US investors ignore are non-US small cap stocks. Even at the index level, the MSCI “All-World” index is comprised completely of large cap stocks. 

You need to use the MSCI “All-World IMI” index to see any representation by smaller non-US stocks – an index unfamiliar to many US investors.

But the result is a missed opportunity for those investors still seeking some degree of non-US allocation within their diversified portfolios. Compare the historical performances of EAFE and EM small cap stocks to their better-known large cap brethren.

Source: Ycharts, data through November 24, 2024. You cannot invest in an index and past performance is no guarantee of future results.

Source: Ycharts, 10-year data through November 24, 2024. You cannot invest in an index and past performance is no guarantee of future results.

What Are the Potential Catalysts for a Small Cap Revival?

Small cap stocks tend to be more sensitive to the economic cycle and to interest rates than large cap stocks. Smaller companies tend to be more reliant on floating rate bank debt and have weaker overall balance sheets and capital structures.

The consequence is that small cap stocks tend to perform better during periods of economic recovery and/or lower or declining interest rates.

Source: BNP Paribas Asset Management, as of November 25, 2025. You cannot invest in an index and past performance is no guarantee of future results.

Source RIA Advice, February 2024. For illustration purposes only – actual results may vary, and past performance is no guarantee of future results.

The Fed has embarked on a rate cut regime (which will bring down rates at the shorter end of the curve), though how aggressive they can/will be is now in question in the face of resilient economic and labor markets and sticky inflation. 

If the Fed does continue to cut rates (even if not at the same pace as originally anticipated earlier this summer), that should benefit smaller companies.

At the same time, incoming President Trump’s stated policy agenda of fewer regulations and lower taxes (if successful) should benefit smaller companies.

The market thinks so. Consider the rally in small cap US stocks since just before the early November election.

Source: Ycharts, One-Month returns through November 24, 2024. You cannot invest in an index and past performance is no guarantee of future results.

A final useful illustration is to examine the performance of small cap stocks in comparison to the confidence and sentiment of small business owners as measured by the National Federation of Independent Businesses (NFIB). 

Not surprisingly, small cap stocks tend to perform better when small business owners are gaining confidence in underlying economic conditions, and vice versa.

Source: RIA Advice, February 2024. You cannot invest in an index and past performance is no guarantee of future results.

And we see an uptick in the most recent NFIB Small Business Optimism Index.

Source: National Federation of Independent Businesses (NFIB) Small Business Optimism Index, through October 2024.

Summary and Interpretation

In the current market environment, in which (in our opinion) short-term rates are likely to fall but longer-term rates are likely to rise, and when there is increasing confidence that the economy will remain resilient, we believe investors should be giving smaller cap stocks a closer look. 

Given historical performance, especially the longevity of outperformance once they gain the lead, long-term investors ignore small cap stocks at their peril. 

Should the Fed continue its rate cut regime and the incoming Trump administration is successful in reducing regulation and taxes (both big “ifs” – we acknowledge), small cap stocks may once again enjoy a relative renaissance.

Combining this with the near historic valuation differential between large cap and small cap stocks means there may be significant relative value opportunities for more patient or longer-term investors.

In addition, for those investors who seek non-US exposure in their diversified portfolios, we encourage them to investigate potential opportunities in non-US small caps, which historically have performed quite well compared to non-US large caps.

We hope you find this analysis useful. As always, please do not hesitate to contact us with any questions.