Through the end of February, micro-cap stocks have been on a highly impressive, market leading run off the April 2025 low. From 4/8/25-2/28/26, the Russell Microcap Index advanced 74.5% versus respective gains of 39.7% and 39.6% for the large-cap Russell 1000 and S&P 500 Indexes. Even after this remarkable bull run, our outlook remains upbeat for the asset class as a whole and for the three micro-cap portfolios that we manage—the open-end Royce Micro-Cap Fund, variable annuity portfolio Royce Capital Fund–Micro-Cap Portfolio, and closed-end fund Royce Micro-Cap Trust.

The key to small- and micro-cap’s sustained market leadership in our view hinges on better relative earnings growth fueled by a robust backdrop for U.S. economic growth. The previous market leaders were of course the “Mag 7” (more recently christened the “Lag 7”), which each face increasingly difficult earnings comparisons associated with the impact of the law of large numbers.

We saw this dynamic begin to play out in 2025, when smaller companies on average had significant earnings outperformance compared to their large- and mega-cap peers—and we expect this trend to continue in 2026.

The micro-cap rally was initially fueled by vibrant performances from lower quality, non-earning stocks, which is typical of the initial stages of a small- and micro-cap bull market. For example, all 11 sectors in the Russell Microcap were in the black from 4/8/25-3/13/26, yet the biggest contribution by far came from biotech stocks in the Health Care sector. (Our focus on quality and/or strong fundamentals means that we tend not to focus on many of these stocks.) Information Technology and Industrials also performed well, however, and these sectors saw more than respectable contributions from industries where we are typically more active (and overweighted versus the index), such as communications equipment, electronic equipment instruments & components, semiconductors & semiconductor equipment, aerospace & defense, and machinery.

Ongoing significant investments in AI spending also helped to fuel this upswing, and our investable universe of micro-cap stocks includes many companies selling into the AI supply chain. While this includes obvious areas such as semiconductor equipment companies, it also reaches a much broader universe of industrial, energy, and power related stocks that will continue providing the picks and shovels for the AI revolution.

One of our underlying views on the sustainability of U.S. economic growth is rooted in the vast amount of fiscal spending that targets domestic infrastructure. While many are currently focusing on the effects of the “One Big Beautiful Bill” Act (OBBBA), we also remain in the early stages of spending from the Biden administration’s Infrastructure Investment and Jobs Act (IIJA) and the associated funding of the Broadband Equity Access and Deployment Program (BEAD) that is bolstering rural telecom infrastructure. These programs support what looks like a long-term trend towards the reindustrialization of the U.S. economy. As many micro-cap companies often receive a relatively outsized benefit from domestic spending, we view this as a performance driver for many businesses in the asset class.

Of course, several risks bear watching, the most glaring being mounting geopolitical risks, not just in the Mideast but across the world. Investors are rightfully focusing on the disruptions to oil supplies from the current military action in Iran, but the sheer magnitude of the potential human cost and the possibility for unexcepted consequences could also pressure political stability in some regions as well as global economic growth more generally.

Similarly, the increasing stress related to private debt held in private equity funds is another concern. Whether it is a harbinger of a broader credit cycle issue that might negatively affect the public banking sector is an open question. It may seem odd, but the extent to which credit risk remains broadly confined to private equity could prove beneficial to micro-caps because private equity is a key competitor for capital within the space.

Here are three holdings in which we have long-term conviction, two that are benefiting from AI spending and one from reindustrialization:

We will continue to use our core approach, where we use multiple investment themes that give us wide exposure to companies with strong fundamentals and/or prospects selling at what we think are attractively low valuations. Despite how well micro-caps have performed over the last several months, we are still seeing what we think are promising long-term opportunities.

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