Beyond the Giants: Exploring the Potential of Small- and Mid-Cap Stocks

The Tide May Be Turning for Small- and Mid-Cap Stocks

After the pandemic, small- and mid-cap stocks didn’t generally enjoy strong earnings growth amid high interest rates and recession worries. Meanwhile, the Magnificent Seven — a collection of large companies tied to technology and artificial intelligence (AI) — generated strong results, including an astonishing 33% earnings rise in 2024.¹

In addition to driving the market higher, the Magnificent Seven have dominated key indexes. As a result, small-caps now represent less than 4% of the broader U.S. equity market, according to investment bank Jeffries. This is the lowest level since the 1930s.

Things may be changing in 2025:

• Earnings estimates have indicated that growth for small- and mid-cap stocks will accelerate while the growth for the Magnificent Seven is expected to slow.

• The Trump administration has pledged to relax business regulations.

• Analysts expect an uptick in merger and acquisition activity and initial public offerings (IPOs).

Even though many investors remain skeptical of small- and mid-cap equities, our outlook for these asset classes is brightening.

Evaluating Small- and Mid-Caps Amid S&P 500's Outperformance

The market moves in cycles: One asset class dominates the other for a period, then something happens, and they switch.

Furey Research Partners indicates that the average cycle for large-caps versus small-caps has typically lasted between seven and 10 years. Based on historical trends, the current cycle of large-caps outperforming small-caps has been extended and may be nearing a reversal.

Analyzing Small- and Mid-Cap Stocks Despite Elevated Costs

Small- and mid-cap stocks ended 2024 with elevated valuations. As of December 31, small-cap valuations were 2% above their 20-year average, and mid-cap valuations were 17% above average. See Figure 1.

But do you know what hasn’t been cheap? Large-cap stocks. The S&P 500® Index traded at a 36% premium to its 25-year average as of December 31, 2024. Large-cap growth stocks — shares of large companies that have historically grown faster than the market average — traded at a 45% premium over the same period.

Given the lofty valuations of large-caps, we believe small- and mid-cap stocks are relative bargains in an equity market where prices are generally higher than historical averages.

Figure 1 shows the largest valuation differences between large-, mid- and small-cap stocks in decades.

Weighing Small- and Mid-Caps Against Large-Cap Earnings Growth

The Magnificent Seven's remarkable earnings growth has helped large-caps outperform over the last two years. While they’re expected to grow at a 20% year-over-year pace in 2025, that’s a slowdown from their 30% growth rate in 2024.²

On the other hand, our analysts forecast that earnings growth for small- and mid-cap stocks could pick up speed in 2025, possibly going from negative to double-digit percentage growth. See Figure 2.

Large, growth-oriented companies, including the Magnificent Seven, remain important parts of an overall investment strategy. However, diversified portfolios that include small- and mid-caps may provide exposure to stocks trading at what we believe are attractive prices and companies with the potential to experience accelerating earnings.

Profitability of Small-Cap Companies

Some 40% of small-cap companies are unprofitable, but the weight of these money-losing enterprises in the investment universe is lower at 19%.³

Many money-losing firms are biotechnology and pharmaceutical companies. These companies are often not designed to be profitable. Instead, they are typically early-stage businesses focused on developing treatments, medical devices or drugs and aiming to be acquired by a larger company.

Of course, small companies in other industries are at heightened risk for bankruptcy. An active manager can navigate the universe of investment opportunities to identify profitable small-cap companies that have historically outperformed unprofitable small-cap firms.

Comparing Growth Potential: Small- and Mid-Caps vs. Large-Caps

Given the trend of reshoring, we believe small- and mid-cap stocks have an opportunity for long-lasting potential. Reshoring is the phenomenon of manufacturing and industrial activity returning to the U.S. It’s steadily picked up since the pandemic. It may get a further boost from Trump’s tariff policies.

Reshoring could drive earnings growth for smaller U.S.-based companies for the next several years if not decades. Smaller companies tend to benefit from increased spending on building and upgrading facilities, manufacturing plants, technology, etc.

Reshoring also supports economic growth, which historically has driven small-cap performance as these companies tend to be sensitive to economic conditions.

Impact of New Tariffs on Small Companies

The impact of Trump’s tariff policies is uncertain. In the near term, tariffs could pose a risk for smaller companies because they typically don’t have large, complex supply chains to maneuver around tariffs.

We believe small-cap companies in certain U.S. industries, including banks and insurance firms, are less likely to face direct impacts from tariffs. In the longer term, small- and mid-cap companies may benefit if tariffs spur reshoring activity.

IPO Activity: Effects on Small Companies

Companies choosing to stay private longer has yielded fewer publicly traded investment options. But we think it’s an exaggeration to say IPOs are dead.

Low interest rates and the availability of government stimulus led to an IPO boom in 2021. Many of these IPOs were driven by special purpose acquisition companies (SPACs) — public companies formed to buy and take private companies public.

There was a rise in IPOs in 2024, and we believe this uptick in offerings could continue into 2025. Major investment banks have suggested a backlog of companies have waited to go public and may now proceed due to increased confidence in the business environment.

This is important because historically, when IPO activity rebounds from a low point like we saw in 2022 and 2023, small-cap performance has tended to improve.⁴

Small- and Mid-Cap Potential

Plenty of change is underway in the U.S., including investors' perceptions of small- and mid-cap stocks.

It’s been a while since these somewhat overlooked asset classes have outperformed large-cap stocks. However, as we’ve highlighted, we think there are potential opportunities for investors to include them in diversified portfolios.