After years of being overshadowed by mega cap tech, investment experts explain why US small cap stocks are drawing attention and money from portfolio allocators
A recent rally in the small cap space has sparked renewed interest from institutional investors who see an emerging value proposition that’s been overlooked in the AI-driven surge of the S&P 500.
Portfolio managers point to a confluence of macroeconomic shifts, policy tailwinds, and broad earnings strength as catalysts driving the movement.
Bob Kaynor pointed to recent earnings announcements as one of the immediate sparks.
“If you want to put your finger on what's driving the recent kind of rotation or favouritism towards smaller cap companies, it's definitely what's come out of earnings season,” said Kaynor, head of US small and mid-cap equities at Schroders. “They beat numbers by a wider margin than large cap, and future revisions were more favourable than we've seen.”
While he acknowledged that market rotations can be choppy, he stressed that sustained outperformance will depend on earnings growth continuing to outpace large caps.
“Small cap earnings growth is going to be greater than large cap earnings growth in the third and fourth quarter,” Kaynor said, noting that this would mark the first such shift since 2022.
He’s not alone in that view as Owen Gibbons, senior portfolio manager of US small-mid cap equities at Van Berkom Global Asset Management, highlighted small caps have delivered a standout performance in Q2, defying expectations and putting pressure on long-standing valuation gaps.
“Small caps in the second quarter came in around 8.7 per cent earnings growth versus an expectation of minus two,” he said. “That’s the largest beat versus expectations since Q1 2022.”
Gibbons added that while large caps also beat earnings estimates, the surprise margin for small caps was roughly double, suggesting the upside has already been priced into their larger peers.
Kaynor also agreed, pointing out that valuations in small caps remain historically compressed relative to large caps, while the potential for earnings acceleration into the back half of the year remains high.
Gibbons argued that small caps, long overshadowed by the S&P 500’s AI-fueled surge, are beginning to show signs of renewed strength. Historically, smaller companies have grown faster and traded at a premium, but in his view, that relationship has broken down over the past three years. Notably, the AI build-out has distorted large-cap valuations, pushing a handful of stocks to levels that don’t make sense.
“When Nvidia becomes larger than 99 per cent of all other global economies, you have to question whether the valuations make sense,” Gibbons said.
He underscored that renewed certainty around tax policy, a more benign inflation outlook, and expectations of Fed cuts have encouraged investors to return to small caps, also suggesting that small caps are set up for more than a short-term bounce, given how overlooked they’ve been in recent years.
“I think small caps have been under owned and under appreciated for probably three years now,” he said, adding that falling rates and lower cash taxes create a strong backdrop.
Meanwhile, Michael Shaw framed Canadian small-cap performance in 2025 as heavily influenced by gold, given that materials make up more than a third of the index, noting the jump from $2,700 to $3,400 an ounce and the nearly 48 per cent gain in the materials sub-index.
But Shaw argued that the focus on gold masks broader strength. Industrial, consumer, and financial names have also delivered solid results, often outpacing large-cap peers. He pointed out that valuations at the start of the year were particularly supportive.
“Canadian industrials, which is a big part of a small cap index, is trading at one of its largest historical discounts to its Canadian large cap peers. We think that there's a room to run on the small cap index, just based on the valuation alone, controlling for some of those commodity moves,” noted Shaw, portfolio manager on Franlin Templeton Investment Solutions' Canadian small cap strategy.
He added that while energy has lagged, “if we see a recovery there, I think that's an area that can provide a lot of juice to the index as well.”
Small caps have started to deliver genuine earnings momentum, with the latest quarter showing one of the strongest beats against expectations in years.
“We've had a number of takeouts in the small cap space,” added Shaw. “We've seen US competitors, private equity, and Canadian strategics all taking a run at small caps. That shows other sources of capital are saying these are good businesses trading at attractive valuations.”
For Gibbons, the broader appeal lies in exposure to the real economy like housing, construction, and consumer spending, rather than the concentrated bets of mega-cap tech. Policy backdrop and macro environment are also starting to tilt in favour of small caps. He argued that the recent tax bill, despite its fiscal flaws, offers a clear advantage for domestically focused companies.
“There’s no doubt that the passing of this tax bill is a boost, disproportionately for small cap companies,” he said, pointing to their higher share of US revenues and the benefit of 100 per cent depreciation allowances that free up cash for reinvestment.
Despite the headwinds, tariffs and inflation trends are factors working in small caps’ favour, noted Gibbons. Because tariffs fall mainly on goods, the costs are being passed through to consumers, who are cutting back on services, something he sees as inherently deflationary.
That dynamic could allow the Fed to cut rates sooner than expected, Gibbons said, noting their heavier debt loads, greater exposure to the US consumer, and sensitivity to changes in discount rates.
What excites Kaynor now is the shift he sees underway.
“For the first time, you’re starting to see the S&P 600 outperform, which means it’s a broadening and it’s a quality-led type rally,” noted Kaynor, adding that unlike the Russell 2000, which has a heavy share of unprofitable companies, the SmallCap 600 Index is a higher-quality small-cap index and its leadership suggests the rally may have more staying power.
Looking ahead, Gibbons sees 2026 as a potential breakout year, emphasizing it could be “a 20 per cent plus year for small caps,” pointing to their attractive valuations and the potential boost from a housing rebound that could extend for several years to come.
