After several years of underperforming their larger counterparts, small-cap stocks have been ideally placed to make a comeback in investor portfolios. As well as offering valuable diversification, smaller companies – especially those in the US – are poised to take advantage of lower interest rates, domestic oriented policies from the new administration and the accelerating pace of innovation.
Why small caps could outperform in today’s environment
Global stock market advances since the end of the pandemic have been underpinned by the success of the world’s biggest companies, in particular, the so-called Magnificent 7 US-based technology firms: Alphabet, Amazon, Apple, Meta Platforms, Microsoft, Nvidia and Tesla. Since the start of the current decade, the valuation gap between small- and large-cap companies has only widened.
But a number of compelling reasons to reappraise US small-cap stocks have emerged in recent months. These range from a more favourable monetary policy environment to the new administration focused on reinvigorating domestic activity. Widespread adoption of artificial intelligence (AI) is happening rapidly and faster than the dotcom era of the 1990’s. The demand for infrastructure to support this trend is immense and extends far beyond notable semiconductor companies. Numerous elements of technological hardware are experiencing a rapid acceleration in growth along with many different industrial companies of all sizes.
The breadth of the small-cap universe, and the fact that the businesses within it are less likely to be covered by analysts, also means that many smaller companies are priced inefficiently.
Small-cap stocks: undervalued and underrepresented?
Across many markets, small caps have lagged large-cap stocks for much of the past decade. This is because larger companies have been better able to weather the storm of high inflation and rising interest rates. Their size has given them greater pricing power and their stronger balance sheets have helped protect against increases in borrowing costs.
As a result, the valuations of large-cap stocks have risen sharply while small caps appear to be significantly undervalued in historical terms. Since the Fed began its rate hiking cycle in early 2022, the valuation discount for small caps compared to large caps has remained at extremes last experienced in the early 2000s.
There is no guarantee that these valuation trends will be reversed in the short term. But factors such as higher for longer interest rates and its disproportional impact on corporate profitability within different size segments has certainly contributed to the widening valuation chasm between large and small and this dynamic may be shifting with more rate cuts now expected imminently. The growth of the largest American technology firms in recent years means that many equity portfolios are now heavily concentrated in just a handful of names. Small caps offer the chance to add valuable diversification for investors still seeking exposure to a more resilient US economy.
A focus on US small caps: poised for success
Moves by the Trump administration to encourage both American and foreign-owned businesses to increase their investment in the US and move supply chains back home may also benefit US small caps given their more domestic focus and higher exposure to the broader economy. US large caps have significant concentration in the technology sector and the most prominent mega cap technology companies (sometimes classified as communication services or consumer discretionary). Meanwhile small caps have significantly more exposure to the broader US economy with higher weights in the industrials, financials, energy and materials sectors.
The resilience of the US economy should offer further support. US GDP decelerated in the first half of the year, but still expanded, and there are signs that the impact of tariffs may be less severe than previously feared. The government has also announced plans to reduce the regulatory burden on businesses and cut taxes (somewhat offset by tariff revenues).
Meanwhile, small caps tend to have higher levels of debt than their larger counterparts, so recent US Federal Reserve rate cuts – with the prospect of more to come – are another tailwind. Lower borrowing costs mean small-cap firms will be able to scale up their investment plans as well as service existing debt. Loan growth in the US has been extremely depressed over the last two years and could spur growth if lower interest rates lead to a return to longer term levels.
Looser monetary policy could also act as a catalyst for a rise in merger and acquisition (M&A) activity: the increased availability of financing for takeover bids could help to unblock the M&A pipeline after a challenging period in capital markets. Large-cap companies as well as private-equity investors are expected to take the opportunity to acquire smaller firms – with company shareholders set to benefit as a result.
AI and innovative opportunities in smaller companies
The rise of AI and the huge levels of capital expenditures by the largest players in AI is creating opportunities for the likes of component providers for data centres or fibre networks. Even outside the tech sector industrial companies are helping in the construction of these new facilities and providing the infrastructure allowing them to operate efficiently.
There is also an abundance of innovation occurring in the healthcare sector, which is also significantly larger in small cap indices compared to large cap. Higher interest rates and drastic reform in government health agencies have led to severe underperformance in the sector, but this should not alter the inelastic demand for health care from an aging population and a plethora of unmet medical needs. Furthermore, with all the genetic sequencing done over the last few years, some of the most impactful innovations will now likely come from translating that work into drugs over the next decade. This is also a part of US markets that remains ripe for a boom in M&A activity.
How we address the small-cap selection challenge
In an investment universe as vast and diverse as US small caps, companies receive far less coverage from analysts and the media. While the growth potential is considerable, investing in what can be newer businesses carries a larger degree of risk, but are much more inefficiently priced and offer more opportunities to exploit this lack of market attention.
At BNP Paribas Asset Management, we recognise that in an asset class as volatile and inefficient as small caps, an active and selective approach – supported by in-depth fundamental analysis and risk management – is likely to be the most effective.
Our goal is to identify attractively valued stocks that have above-average growth potential to build a portfolio that is full of robust ideas and capable of performing consistently in a variety of market environments.
Our investment team comprises sector specialists, many of whom manage a range of portfolios – within and outside the small-cap segment – that relate to their specific expertise. By focusing on the active risk of the portfolio at the individual stock level, we have been able to deliver more consistent outperformance with lower levels of tracking error relative to the benchmark.1
The improvement in conditions for US small caps expected going forward means we are increasingly confident in the prospects for our strategy – and we believe this presents a great opportunity for investors to gain exposure to the US market while adding a valuable degree of diversification to their portfolios.
Find out more about how the BNP Paribas US Small Cap strategy is positioned to take advantage of the asset class tailwinds.
[1] Source: BNP Paribas Asset Management, September 2025
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