Small Cap Performance Potential

Roughly 12 months ago, small caps outperformed mega-cap stocks in July. The catalyst for this was high valuations for large caps compared to discounts for small caps. Additionally, loose interest rate expectations and the hope that Candidate Trump’s tariffs would eliminate competitive pressure for small caps boosted their performance. The dot-com bubble exhibited a similar movement, sparking comparisons with the Russell 2000's outperformance of the Russell 50 index over the following 12 years. Yet, this confidence faded quickly as this trend didn’t last.

A year later, mega caps and AI-dominance continue to be the face of performance. Since 2021, the S&P 500 has returned a little less than 70%, of which roughly 54% of the total gain can be attributed to the 10 biggest companies. As of now, these large companies are supporting their monumental valuations with strong margins and quarterly reports. This still brings concentration risk as the premium in large caps’ book multiple is the widest it’s been in 25 years.

This raises the argument that small caps’ cheapness could mean that there is under-appreciated growth potential. Perhaps there is undiscovered value in the investment, which could hedge against large corporations if we see any volatility. Yet, companies, with only a few exceptions, are judged on a quarter-to-quarter basis and get rewarded for posting revenue beats. Until small caps consistently perform to expectations, they may not provide the result some hope for.