Are smaller companies about to have their moment?

Companies with smaller market value are trading at the widest discount to large caps in more than 20 years

Over the past month, the Russell 2000 index of smaller firms grew 6 per cent, three times faster than the S&P 500 at 2 per cent. Getty Images

Small is beautiful, they say. Unfortunately, this hasn’t applied to smaller companies lately, which have fallen badly behind their large-cap rivals.

Lately, investors have been thinking big. Very big, in the shape of the trillion-dollar US mega-cap tech stocks like Amazon, Apple, Microsoft and Nvidia, that have dominated global portfolios.

They’ve sucked up all the attention as they deliver the kind of returns investors might expect from young, fast-growing companies.

Nvidia is the obvious example. Its shares have skyrocketed 1,270 per cent in the past five years. That’s the kind of return investors might dream of when buying penny stocks, not the world’s biggest company, now worth $4.28 trillion.

Over the past five years, the S&P 500 large-cap index has grown by 85 per cent, while the Russell 2000 index of smaller firms is up just 50 per cent.

In the UK, conditions are equally tough. The Alternative Investment Market (AIM) has fallen 25 per cent over five years, at a time when London’s FTSE 100 blue-chip index climbed 54 per cent.

Richard Penny of Oberon Investments, a long-time UK small-cap and AIM specialist, has called AIM “the worst I have ever seen it”, given entrenched dislike by both domestic and international investors.

Investing is cyclical, and Mr Penny suggests that at some point the tide will turn. The problem, as ever, is that nobody knows when.

Traditionally, smaller companies have a strong track record of outperforming larger peers, but with more volatility along the way. Given how far they are trailing today, taking a chance on them may be worthwhile, though not without risk.

But there are signs that smaller companies are picking up, with the S&P 500 and Russell 2000 running neck and neck lately. Both are up 10 per cent in the past six months, while over the past month, the US small-cap index grew 6 per cent, three times faster than its large-cap rival at 2 per cent.

Kirsty Desson, manager of the abrdn Global Smaller Companies Fund, says performance is improving and valuations are tempting. “Investors can no longer ignore the valuation gap. Smaller companies are trading at the widest discount to large caps in more than 20 years.”

Others have noted the gap, too. Tony Hallside, chief executive of STP Partners in Dubai, says small companies have faced one of their toughest stretches in decades. “Yet that very weakness has created compelling value.”

On price-to-book and price-to-sales ratios, US small cap companies now trade at discounts not seen since the late 1990s, Mr Hallside says.

“In August, the Russell 2000 rallied 6.6 per cent, more than double the S&P 500’s gain, as markets priced in potential US Federal Reserve rate cuts. Historically, valuation gaps of this size and long periods of underperformance have been followed by stronger rebounds when conditions turn,” he adds.

We may not be there yet. Small caps are more cyclical and more sensitive to borrowing costs than larger peers.

With US inflation still above target, the Fed may move cautiously. Even so, Mr Hallside believes the balance is tilting: “Today’s depressed valuations and extreme pessimism mean small caps could deliver outsize returns once confidence and liquidity return. Although volatility is inevitable.”

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Amol Shitole, head of fixed income at Mashreq Capital, also sees conditions shifting. “Since the pandemic, small caps have underperformed relative to large caps, weighed down by tighter financial conditions and higher rates,” he says. “But US small-cap firms are particularly sensitive to monetary policy, with half of their debt tied to floating rates. A meaningful reduction in the federal funds rate could ease financing costs and support earnings recovery.”

Markets are currently pricing about an 85 per cent probability of a 25-basis-point Fed cut in September, with just over half a percentage point of cuts pencilled in for the rest of 2025. Historically, the Russell 2000 has delivered strong returns in the year after the Fed ends a rate-cutting cycle, Mr Shitole says, driven by improved credit conditions and stronger domestic demand.

But he warns against indiscriminate buying. “A significant portion of the index is unprofitable. Rather than broad exposure, we see greater merit in identifying a narrow set of companies with resilient cash flows, pricing power, and strong balance sheets.”

Vijay Valecha, chief investment officer at Century Financial, says investors have been waiting all year for a small-cap rally that never quite arrived, derailed by US President Donald Trump’s tariffs, high borrowing costs and wider economic uncertainty.

Yet Mr Trump could come to their rescue. Smaller firms are much more exposed to their domestic economy, with small caps generating around 80 per cent of their revenue in the US compared to 60 per cent for the S&P 500.

That means they stand to gain more from Mr Trump’s efforts to revive US manufacturing, production and innovation. “Reshoring and supply chain investments could favour US small caps, boosting revenue growth,” Mr Valecha says.

So, how to invest? Most say new investors will favour a fund over individual stocks, and this is an area where active fund managers often claim they can shine, by picking out tomorrow’s winners.

US small-cap firms are particularly sensitive to monetary policy, with half of their debt tied to floating rates

Amol Shitole,
head of fixed income, Mashreq Capital

Mr Valecha is not convinced. “Almost 80 per cent of active fund managers fail to outperform their benchmark indices. Hence, it makes sense for investors to pursue investing via a passive fund.”

He highlights two US exchange-traded funds (ETFs) to consider: the iShares Russell 2000 ETF and the Vanguard Small-Cap ETF. Investors who want to look further afield may consider global ETFs such as the iShares MSCI World Small Cap or SPDR MSCI World Small Cap. There are plenty of regional and country-specific ETFs, too.

Yet in one respect, ETFs may also be part of the small-cap problem. The relentless popularity of passive investing has channelled ever more money into the biggest stocks, squeezing out smaller ones.

Laith Khalaf, head of investment analysis at AJ Bell, says: “Tracker funds are more heavily weighted to large-cap stocks than typical active funds, which are often overweight smaller companies. When big companies do well, index trackers rule the roost.”

Small caps may finally be turning a corner, but it’s far from a done deal. Chris Beauchamp, chief market analyst at IG, says the big guns aren’t giving up without a fight, following Nvidia’s positive numbers last week.

“The sky hasn’t fallen in despite the lack of real fireworks in the chip titan’s earnings, while Google-owner Alphabet has surged to a new high,” he adds.

For now, the giants remain in charge, but smaller companies are stirring. Patient investors willing to stomach the volatility could find today’s deep discounts hard to ignore. Others may struggle to tear themselves away from the mega-caps.