Talking Heads – Full steam ahead for US small caps

Talking Heads – podcast recording US small caps

Andrew Craig: Hello and welcome to this week’s BNP Paribas Asset Management Talking Heads podcast. Every week, Talking Heads will bring you in-depth insights and analysis on the topics that really matter to investors. In this episode, we’ll be discussing the prospects for US small-cap stocks. I’m Andy Craig, Co-head of the Investment Insight Centre, and I’m joined today by Geoff Dailey, who’s Head of US Equities in Boston. Welcome, Geoff, and thank you for joining me today.

Geoff Dailey: Thank you, Andy. Happy to be here.

AC: Let’s start by reviewing the performance of small-cap stocks this year. Can you talk us through what’s happened?

GD: Yes, it’s been another volatile year for small caps. Performance and sentiment can be split into two distinct periods. In the first phase that ran through early April, investors were clearly pessimistic. We saw the Russell 2000 decline over 20% from the start of the year through April 8. What led to this weakness? We had a few downbeat macro data points that caused some consternation about US
economic growth. And we had the uneven communication on policy from the administration that also weighed on investor sentiment. That policy rhetoric culminated with the extreme tariff announcements on ‘Liberation Day’ and that led to another sharp sell-off, particularly in small-cap stocks. So, this phase of the market was clearly risk-off.

But the market did turn too pessimistic on the US and small caps at this point. By mid-April, a healthy rotation started. Investors started to see value emerging in small caps and a positive catalyst path ahead. That positive catalyst path included the de-escalation of trade talk, lower interest rates and expansionary fiscal policy on the horizon. We also went through an earnings period. The big tech companies put up great revenue numbers, great free cash flow numbers. And importantly, they announced big capital spending numbers, which supported small caps and improved sentiment on the market more generally. So, in that recovery, the leadership was driven by cyclicals, it was driven by tech, it was driven by tariff-exposed names, while the defensive industries lagged. It’s a complete reversal from that first phase and in that period from April 8 until just the other day, the small-cap market was up 40%. Clearly, investors are starting to re-engage with US small caps.

AC: We’re talking in the third week of September, a week after the US Federal Reserve restarted its rate cutting cycle with a 25-basis point rate cut. What’s your outlook for small caps from here? What do you see as the potential drivers for the market and what do you see as the risks?

GD: We think the renewed enthusiasm is well placed. First off, there’ll be a broadening of market participation and small caps are a clear way to play that trend. Generally, small caps provide more cyclicality and more domestic leverage than [their] larger-cap peers. One factor that will drive this broadening and small-cap strength is the recent passage of the Big Beautiful Bill. This includes tax cut extensions for individuals and small businesses that help provide certainty for those making investments. Importantly, the bill introduced new incentives for investment like the immediate depreciation of capital expenditures and research and development spending, which we believe will drive incremental domestic capex spend. We’ve already seen this. We’ve seen a number of announcements of big expansions from players in the pharmaceutical industry, from datacentre players, semiconductor manufacturers, and there’s more to come.

This fiscal boost to domestic investment adds fuel to the structural domestic reshoring story. We like that backdrop for small caps because they’re levered to domestic investment and a capex cycle would, would benefit them.

On top of those fiscal measures, we’re going to see a wave of deregulation that will promote domestic growth and investment. We expect faster permitting of projects, more lending by banks, fewer compliance costs and lower barriers to mergers and acquisitions. That M&A theme is an important leg of the stool for growth for small-cap investors because M&A has been depressed since 2021. That’s all changing now. Banks are lending again, financing costs are coming down, regulatory hurdles are lower. Global M&A activity is up over 30% year-to-date and commentary from the investment banks is there’s more to come. This will be a multi-year cycle, and a healthy M&A environment provides a structural boost to small-cap valuations.

The last positive tailwind to small caps is that rate environment. We’ve had a number of false starts as it relates to timing the Fed easing cycle, but we’ve had a cut in September, and the expectation is there’s more easing ahead. This would be a stimulative for small-cap stocks.

Valuations have gotten slightly richer for small caps since the April lows with the forward P/E [ratio] now above the long-term average. We think that’s rational at this stage. You have earnings accelerating, so that P/E [multiple] will be coming down fast. We’re entering a period where the market backdrop justifies a structurally higher multiple compared to recent history. All in all, an attractive backdrop: we have government stimulus, deregulation, domestic capex growth, lower rates, an M&A wave and, importantly, accelerating earnings growth.

Clearly, we have to watch for signs of an economic recession, a further bubbling up of geopolitical tensions, any significant changes to long-term inflation expectations, but we’re not seeing it at the moment, and we’re prepared to take advantage of any volatility that may arise in the small-cap world.

AC: It does sound like a very positive environment, Geoff, within this context, which are the sectors or types of topics that you see as particularly interesting right now?

GD: The nice thing about small caps is with diligence and fundamental analysis, they’re always mispriced idiosyncratic opportunities to uncover. We’re still finding opportunities with attractive risk-reward balances across all our sectors. I’ll highlight a few areas that are particularly interesting right now.

One is small-cap banks. This is an area where fundamentals are starting to get better and it’s a group that’s trailed the broader market in performance and remains reasonably valued. On the valuation side, banks traded at almost half the market multiple and below their own long-term average at 11 times the forward price-to-earnings ratio. On the fundamental front, we see the potential for a strong earnings revision cycle and double-digit earnings growth into 2026, led by a positive Inflexion in loan growth and better lending spreads given the Fed’s cutting short-term interest rates. On the credit quality front, it’s been very benign, and absent a recession, we don’t see material degradation.

The other concern for small-cap banks has been their exposure to commercial real estate. We’re seeing a bottoming of the commercial real estate markets. We’re seeing an improvement in pricing, an improvement in activity, and that bodes well for small-cap banks and sentiment towards small-cap banks. Much of the investor focus has been on the larger-cap banks. We think this could shift to the small-cap banks as loan growth and spreads improve. Again, we need to continue to monitor the strength of the economy, but it looks like a pretty good story for small-cap banks.

In the technology sector, we have exposure to AI-leveraged small caps like semiconductors, infrastructure and networking companies. They’re all prospering right now. But we also see value in select software niches. Cybersecurity remains a secular growth category. We also remain interested in supply chain management software companies that have been left behind in the race for AI exposure. We’re finding double-digit growth, high-margin, high free cash flow software companies that are trading at a discount right now.

Lastly, we’re finding ideas related to our structural growth themes. One of those themes is innovation within healthcare, in those med tech and biotech sectors that are going to take share in these massive growing markets. The second durable theme is that capital expenditure renaissance in the United States. We’re finding companies leverage off building factories and datacentres and broader infrastructure plays that we believe are attractive value. So, no shortage of attractive stocks if you know where to look.

AC: Are there areas or segments of the small cap investment universe that you’re avoiding at the moment?

GD: One area we’re generally cautious on is traditional consumer staples companies. These companies are facing competitive pressures that are impacting pricing power and weighing on their margins. Many of these companies are having a difficult time innovating, so they’re losing share. We don’t see this group as particularly undervalued. So, we’re being very selective in traditional consumer staples.

On the other end of the spectrum, the higher growth spectrum, we see pockets of froth that we are being very selective in or avoiding altogether. These are the uber-high growth niches that have reached speculative levels from a valuation perspective:  small-cap drone and defence companies, some crypto firms, satellite firms and even quantum computing firms. Many of these companies have immature business models and are trading more on speculation than underlying fundamentals.

AC: There’s clearly opportunities currently in the US small-cap investment universe. Thank you very much for joining me today.

GD: Thank you again, happy to be here.

AC: That’s it for this week’s episode of Talking Heads. If you’d like to learn more, please reach out to your BNP Paribas Asset Management contact or check out Viewpoint, our website for investment insights at viewpoint.bnpparibas-am.com. We recommend subscribing to Talking Heads on your favourite podcast channel such as YouTube or Spotify. You receive your podcast episodes every week. If you like Talking Heads, please leave us a positive review and a nice rating. You’ve been listening to the BNP Paribas Asset Management Talking Heads podcast with me, Andy Craig and Geoff Dailey. Please do join us again next week. Until then, take care.