No More Excuses for Small Caps

In the pre-Covid world, many investors assumed that small caps provided the best exposure to fast-growing stocks, juicing the odds of potentially generating massive returns—the elusive “ten bagger.” Today, this presumption is under scrutiny as hypergrowth from huge businesses has propelled the market capitalizations of single companies—including Nvidia and Microsoft—beyond that of the entire Russell 2000. 

The litany of factors contributing to the underperformance of small stocks relative to large in recent years is familiar but worth revisiting. In our view, the unique confluence of zero interest rates and money printing by the federal government combined with notable earnings from the largest companies in the US triggered the divide. Meanwhile, Russell 2000 Index earnings left much to be desired from 2021 to 2024, providing investors with further motivation to avoid the asset class. 

However, we now find ourselves at a juncture where many of drivers of poor performance have dissipated. Although the US still has a massive budget deficit financed by massive bond issuances, we are no longer printing money at the same frenzied pace as the Covid era. Gone, too, are the zero policy rates that plagued the Russell 2000’s small banks while bolstering earnings for large cap, high-growth, long-duration tech stocks. Small cap earnings trends, too, have shifted to the positive after several years of declining growth. 

To us, these mounting tailwinds combined with what we consider attractive valuations suggest there is more than enough potential opportunity in turnarounds, undervalued growth stories and asset plays to compensate for the risk of owning small stocks.