Equities

The Case for Small Cap Selectivity

Bill Hench Headshot
Bill Hench

Head of Small Cap Team and Portfolio Manager

Smaller stocks surged in the second quarter, outperforming their large cap analog for the second consecutive quarter, as easing Middle East tensions buoyed investor confidence. Similar to trends in the large cap space, smaller-stock index performance has been quite concentrated, with energy leading in the first quarter and tech rebounding in the second.1

The capital investment to build out artificial intelligence (AI)-related infrastructure has been a source of support across markets. Spending on data-center software and information processing equipment relative to GDP, which now exceeds the dot-com peak, is forecast to continue.2 Even if spending moderates, the long-term nature of projects like data centers suggests hyperscaler capex may be a source of support for smaller companies.

We think the sharp run-up in certain sectors reinforces the critical importance of exercising strict valuation discipline. However, we are excited about undervalued opportunities in sectors like in healthcare or consumer staples, or where we can identify more idiosyncratic turnarounds.

Smaller stocks in general should find support going forward in resurgent fundamentals. For example, published forecasts reflect 85% earnings growth for the Russell 2000 Index in 2026 and 44% in 2027 compared to 27% and 18%, respectively, for the S&P 500 Index. Revenue growth, too, is forecast to improve over the next several quarters.3

 

Smaller stocks in general should find support going forward in resurgent fundamentals.

In addition, the reopening of the initial public offering (IPO) market in recent quarters has increased the number of stocks in our universe.4 Moreover, there is a vigorous pipeline of mature, high-profile companies and smaller portfolio companies from private equity firms. Additionally, companies that postponed IPOs due to government shutdowns could reemerge, facilitated by a benign regulatory environment focused on increased capital access and reduced compliance burdens.5

1 Source: FactSet; data as of June 30, 2026.
2 Source: Reuters; data as of March 17, 2026.
3 Source: LSEG I/B/E/S; data as of July 9, 2026.
3 Source: PwC; data as of July 10, 2026.
3 Source: Cleary Market Watch; data as of February 5, 2026.

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Past performance does not guarantee future results, which may vary. The value of investments and the income derived from investments will fluctuate and can go down as well as up. A loss of principal may occur.

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Capital expenditure (capex) is spending on physical, long-term assets, such as property, plant or equipment, to grow or maintain operations, which are capitalized on the balance sheet and depreciated over the asset's useful life.

Gross domestic product (GDP) measures the total value of all economic output in goods and services for an economy.

Russell 2000® Index (Gross/Total) measures the performance of the small-cap segment of the US equity universe. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership. A total-return index tracks price changes and reinvestment of distribution income.

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