Small-caps have lagged for much of the past several years as higher interest rates, rising costs, and narrow, mega-cap market leadership all worked to compress valuations and mute earnings visibility. This dynamic, however, is beginning to shift. Year-to-date, small-caps have outperformed large-caps, and since the market low on 4/8/25, the Russell 2000 has risen more than 50%, outpacing the Russell 1000, which gained around 40% over the same period. And while sentiment has improved, valuations remain discounted, and fundamentals are starting to turn.

One important driver is the interest-rate environment. Small-cap companies typically carry more leverage and have greater exposure to floating-rate debt than their large-cap peers. As financial conditions become less restrictive, interest expense tends to fall more quickly for smaller companies, leading to a disproportionate benefit to earnings. This pattern has been evident in prior easing cycles, when small-cap earnings growth accelerated relative to large-caps, often before the improvement was fully reflected in consensus estimates.

Tax policy is also becoming more supportive. Provisions enacted in mid-2025 are improving after-tax cash flow for many domestically focused companies, particularly those without access to complex international tax structures. Incentives tied to capital investment and R&D support further reinvestment, productivity gains, and margin expansion—factors that tend to matter more for smaller companies, especially those that are earlier in their growth trajectories.

At the same time, the reshoring of supply chains remains a durable structural trend. As manufacturers prioritize resilience and proximity over lowest-cost production, demand continues to shift toward domestic suppliers and specialized service providers. Many small-cap companies occupy compressed but critical positions in these ecosystems and directly benefit from incremental domestic investment, unlike multinational firms whose exposure is more diffuse.

Technology adoption is another supportive factor not yet appreciated by the market. Most impactfully, AI is no longer confined to large-cap platforms. For smaller companies with lean cost structures and high operating leverage, even incremental productivity gains can have an outsized impact on margins, creating a pathway to earnings growth that does not rely solely on revenue acceleration, a distinction that becomes increasingly relevant as the economic cycle matures.

Finally, deregulation is a potential tailwind. Compliance costs are largely fixed and so weigh more heavily on smaller companies. Any easing of regulatory burdens—across diverse economic segments such as financial services, industrials, energy, and healthcare—can improve margins and free cash flow for small-caps more meaningfully than for large-caps, which can more easily absorb such costs.

Taken together, these factors point to an improving earnings environment for small-cap stocks at a time when valuations remain well below large-cap levels. This is not a case for indiscriminate exposure, however. Dispersion within the small-cap universe remains high, and balance sheet strength, pricing power, and management skill continue to matter.

History suggests that when earnings expectations begin to rise from depressed levels, small-caps can deliver meaningful performance. The current environment appears increasingly consistent with that setup. As experienced small-cap investors, we are admittedly biased—but our unshakeable conviction is that active and disciplined small-cap management will matter more and more as the cycle rolls on.

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