Having been overshadowed by their large-cap peers in recent years, US small-cap companies are set for a renaissance as investors seek diversification.
Aside from attractive relative valuation prospects, several tailwinds have emerged for small caps in the US that we believe will provide long-term momentum.
Periods of shifting market dynamics can create opportunities, with volatility leading to mispricing. In addition, small caps can also be a breeding ground for innovation.
Therefore, despite short-term volatility, the prospects for US small caps are compelling.
Time for a reversal of small-cap underperformance?
Small-cap stocks have the potential to generate rapid appreciation, as these businesses are often in an earlier stage of development and, therefore, can grow faster than larger companies from a smaller base. That said, they can also be less efficient, more prone to failure, and are considered more vulnerable to macroeconomic concerns. Knowing where to invest and what to avoid is particularly valuable within the small cap arena.
Over the last decade US small caps have fallen out of favour – having largely been eclipsed by the excitement, hype and superior earnings generated by the technology mega caps. As a result, relative valuations between large and small caps have fallen from their 2011 peak of around 1.2 to around 0.6 at the end of 20241, well below the long-term average. This represents the biggest market discount for small caps versus large caps in decades2.
Yet, a significant improvement in earnings for US small caps alone could drive prices higher and may also provide the momentum needed to narrow this valuation gap, supplementing the potential performance in such a scenario. Robust earnings growth of 42.3% in 2025 and 39.9% in 2026 have been forecast by consensus estimates, which compares to just 2.6% in 2024 and a historical earnings growth rate of 13%3. This catch-up trade should create a host of opportunities for investors.
Drivers to unlock small-cap potential
The potential for US small caps is not just down to earnings. There’s a wealth of emerging catalysts that should provide further momentum.
Firstly, monetary policy. The Federal Reserve commenced its much anticipated policy pivot in September 2024, with its first rate cut following an aggressive tightening cycle beginning in 2022. Despite 100 bps of cuts already having taken place, more are expected, albeit at a slower pace. An easing cycle is generally beneficial for small companies as it lowers the cost of debt, thereby boosting sentiment and aiding profitability. Small cap companies are also more dependent on external financing, so rate cuts should be more beneficial for small caps, relative to large caps.
Secondly, US economic resilience is also supportive of small caps. Despite recent market volatility and wavering business and consumer confidence, potential economic tailwinds that were in focus last year, have now been overshadowed by investor pessimism. However, these potential catalysts remain in place, including the revival of US domestic capital expenditure through the reshoring of manufacturing and the building of critical infrastructure. The Trump administration is also implementing a series of pro-growth policies, such as deregulation and potential corporate tax relief. Strong economic growth is particularly beneficial to US small-cap companies as they tend to be more domestically aligned.
A third catalyst reflects expectations for a big cycle of merger and acquisition (M&A) activity going forward. Interest rates are lower, more financing is available and regulation should be more supportive going forward, which should translate into a strong pipeline of deals, with immense pent-up demand after years of capital market stagnation. This momentum is not only coming from corporate executives keen to grow their businesses, but private equity also has capital sitting on the sidelines, waiting for the right opportunities. For strategic buyers, small caps represent a prime source for deal-making.
Despite these tailwinds, investors still need to be mindful of potential risks. The flood of policy announcements from the new government is unnerving markets and creating uncertainty. While the combination of positive valuation and macroeconomic forces is creating a more constructive backdrop for small caps, short-term noise and volatility could also create mispricing opportunities.
Hub for disruptive innovation
The breadth and depth of the small-cap universe are alluring for investors. Often led by founders or small management teams, smaller companies can quickly adapt to changing market dynamics.
As well as specialising in niche sectors, disruptive and innovative smaller companies can be found in even the most traditional or defensive sectors. And their differing sectoral exposure and revenue sources can provide access to different risk characteristics compared to large-cap stocks. Even so, the best fishing ponds are innovative growth sectors, such as healthcare and technology, where attractive companies are levered to artificial intelligence, automation, cloud computing, robotics, medtech and genetics.
Innovative healthcare is an area that has been under pressure in recent years from higher interest rates, tighter financing and generally poor sentiment. However, this means stock valuations are now attracting greater interest, particularly in medtech and biotech companies. Many of these companies are highly innovative, providing solutions for unmet clinical needs in large addressable markets. In addition, M&A is expected to be particularly active in this area. Cash-rich, large-cap pharmaceutical companies are facing a major patent cliff, with close to USD 170 billion of 2024 sales going off-patent by the end of the decade4. Many will seek to replace these revenues by acquiring small-cap biopharma companies,
The arms race for artificial intelligence (AI) is not solely advancing the fortunes of large-cap pioneers. AI already has far-reaching investment implications for small caps, many of which are AI enablers that are reaping the rewards as use cases proliferate. Component providers of digital infrastructure, such as data centres, fibre and mobile network towers, are benefiting from the massive investment cycle being fuelled by AI growth. Flash storage systems for both hardware and software are being deployed by AI supercomputers and also have the potential to be used in cloud services’ AI applications. Cybersecurity software developers are profiting from the increase in the number and complexity of cyber threats to both businesses and governments. These firms are now deploying AI to enhance their security protection products to combat these threats.
The small-cap firms in the AI space often have attractive financial characteristics: strong top-line growth, solid profitability and clean balance sheets, so many good companies. Identifying those companies making the best use of the AI ripple effect will be key to capturing these opportunities, particularly as innovation continues, costs come down and usage increases.
Active and selective approach required
Although there is no shortage of interesting small-cap opportunities, the US universe is large and very diverse in quality.
Unlike large caps, small-cap businesses don’t tend to be widely known and there are far fewer analysts covering these companies. On average, only five analysts focus on small caps versus 15 for large caps and 25 for the mega caps5. While this information gap creates a lot of scope to identify idiosyncratic opportunities, a great deal of fundamental analysis is required to avoid unnecessary risks.
In addition, many companies in this universe are relatively immature, and the quality of their management teams may vary. Again, a rigorous evaluation of how a business is run and the strength of its balance sheet is needed to find high-quality businesses.
Small caps can be an inefficient and volatile asset class; to harness its full potential, an active and selective approach is ideal.
Finding the best small-cap opportunities
Is it time for investors to re-think their equity allocation? After a decade of underperformance, there is now an array of catalysts unlocking the potential of US small caps. Changing economic dynamics, potential for strong earnings growth, and disruptive and innovative forces are just some of the factors driving long-term opportunities across this asset class.
At BNP Paribas Asset Management, we combine the multiple perspectives of secular investment themes with rigorous analysis to identify the mispriced, quality companies that will drive returns and present the best opportunities to investors.
[1] The outlook for US small caps in 2025
[2] Now is a great time to invest in US small caps
[3] Factset, BNP Paribas Asset Management, as at 17 March 2024
[4] Talking Heads – US small caps: looking beyond the near-term uncertainties
[5] The case for US small-cap stocks in 2024
