Setting the stage for small caps in 2025

In making the case for small-cap equities in 2025, our small-cap equity portfolio managers outline several key themes to consider, such as valuation, market cycles, and economic conditions.

Valuation and market cycles

It may be a good time to consider small-cap equities because the cycle of large-cap outperformance is arguably getting long in the tooth. Historically, large- and small-cap equities have traded cycles of outperformance lasting an average of 11 years, and we’re currently 14 years into this cycle of large-cap outperformance, according to small-cap core Equity Portfolio Manager Peter Carpi. Carpi points out that the large-cap cycle appears to be in its final stages, as suggested by increasing narrowness and unsustainable valuations. As such, it may be prudent to consider repositioning into small caps because the greatest gains in each cycle have historically occurred at their outset and just before their end.

Smid/mid-cap value Equity Portfolio Manager Greg Garabedian also highlights the extended period of large-cap outperformance versus smid/mid caps. "The Russell 2500 Value and Russell Mid Cap Value indices have been trading near record-low valuations relative to the S&P 500 Index," he notes. 

Figure 1

Within the small-cap space, the smallest, institutional-grade, publicly traded companies — micro caps — may be undervalued. Micro-cap Equity Portfolio Manager David DuBard notes that these companies are often overlooked because they fall just below the "market cap bar of relevance," where larger-cap investors typically focus. "The micro-cap market has been out of favor as investors have shifted toward larger, more liquid stocks, making it one of the few asset classes that has become less efficiently scrutinized in recent years," he explains. He believes current market conditions are ideal for generating alpha by identifying undervalued opportunities in the micro-cap space.

Economic conditions and growth prospects

There are reasons for optimism in small caps from an earnings perspective, as well. "Small caps are finally expected to see their earnings growth exceed large caps’ after several years of underperformance," says small-cap growth Equity Portfolio Manager Ranjit Ramachandran. What’s more, after trailing the S&P 500 Index in earnings and sales growth for the last two years, earnings growth is expected to accelerate for small caps as a group. Relative valuations are also close to multiyear lows. Small-cap value Equity Portfolio Manager Sean Kammann outlines further reasons to believe in small-cap performance in 2025. He points to trends such as deglobalization, increasing confidence in small businesses, and the recent lift in employment as indicators of an accelerating economy. "Small-cap value companies are collectively more short cycle; this acceleration points to a favorable fundamental backdrop for small-cap value companies," he says. He also notes that historically, the small-cap value area of the market has outperformed over almost any medium- to long-term holding period.

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Sector diversification and M&A activity

Garabedian also highlights the diverse sector exposures smid- and mid-cap value companies offer compared to large-cap counterparts. "Smid- and mid-cap value offer more diverse sector exposures than large caps, where more than 40% of the S&P 500 Index weighting comes from IT and communication services," he says. He believes a broadening of economic growth and/or slowing of AI capex activity could relatively benefit more diversified smid-cap exposures in areas like financials and industrials.

Additionally, Ramachandran and Garabedian point to a more accommodative regulatory stance in Washington, which should continue to accelerate the level of deal activity in markets. "Smid caps generally see the biggest relative benefit from an increasing M&A environment given the higher likelihood of being targeted for acquisitions," Garabedian explains. Ramachandran notes, "Historically, lower taxes, deregulation, and lower interest rates have provided a positive backdrop for more domestically focused small-cap companies."

Conclusion

Our small/smid portfolio managers see a range of factors that make their respective investment spaces appealing in 2025. Their insights on undervaluation, market cycles, economic conditions, and sector diversification provide a comprehensive view of the opportunities available to allocators in the coming year.