How a Year of Uncertainty Became a Year of Double-Digit Returns

In July of last year, we observed that the year’s first six months had given investors nearly every kind of investment weather. The second half of the year proved equally eventful, with two significant differences: first was the long-awaited absolute and relative strength of small- and micro-cap stocks following the market’s bottom in spring of 2025. Second was the related fact that investors were far more at ease with uncertainty in the last three quarters of the year than at the beginning of the year.

The onset of 2025 saw tariff talk (as well as a volatility inducing “now you see it, now you don’t” approach to implementation), stubborn inflation, declining consumer confidence, and a consequent revival of recession fears, all of which worked to keep stocks underwater in 1Q25. The markets then fell even further (and faster) following “Liberation Day” on 4/2/25, in which President Trump announced a broad set of tariffs and other changes to trade policy. So, while the president characterized these moves as a return to “economic sovereignty,” investors disagreed. There is almost nothing markets hate more than uncertainty, and the first few months of 2025 offered more than the usual amount.

Among the most interesting developments in the year, then, was how quickly and easily investors changed course as they were soon taking advantage of the opportunities bred by the tariff-induced downturn. Equities quickly recovered after bottoming on 4/8 in spite of a long list of uncertainties and challenges, including ongoing war and violence in the Ukraine and Gaza, persistent (though moderate) inflation, a declining U.S. dollar, slowly rising unemployment, and a lack of confidence among U.S. consumers. To this list, we can add newer, potentially troublesome developments in Iran, Venezuela, and (of all places) Greenland, as well as the increasingly fractious relationship between the Trump administration and Fed Chair Jerome Powell, whose tenure is likely ending later this year in May.

Micro-Caps Reach the Peak of a Resilient Market

In this challenging context, the equity markets showed remarkable resilience, perhaps because, at the same time, the U.S. economy remains solid, unemployment is low, oil is cheap, and the Fed cut interest rates three times last year (which also lowered mortgage rates). Following April’s bottom, investors were happy to weigh positive developments more heavily than the uncertainties. Looking at the VIX—the CBOE S&P 500 Volatility Index, often referred to as the ‘fear gauge,’ which measures the S&P 500’s expected 30-day volatility—shows a sharp increase near the end of 1Q25 that then subsided through the rest of the year. Throughout the last nine months of 2025, the market remained uncommonly placid, with the VIX sitting lower than its long-term historical average of 30. It merely approached, though never reached, that level in brief spurts during October and November when the AI trade showed signs of unwinding. (It has also crept upward at times in the first few weeks of 2026.)

The upshot was a terrific year for the major U.S. indexes, though the big winner might come as a surprise to some. The Russell Microcap Index led the way, while small-caps trailed large- and mega-cap stocks (thanks in large part to a dismal first quarter for the small-cap Russell 2000 Index). For 2025 as a whole, the Russell Microcap was up 23.0%, the Russell 2000 gained 12.8%, the large-cap Russell 1000 Index rose 17.4%, and the mega-cap Russell Top 50 Index increased 19.9%. The calendar-year spread between the small- and micro-cap indexes was the third widest since the latter index’s inception in 2000. (Results for non-U.S. stocks, which have finished behind their stateside peers over the last several years, were also notable in 2025, with the MSCI ACWI ex-USA Small Cap Index advancing 29.3% and the MSCI ACWI ex-USA Large Cap Index gaining 32.5%.)

An Impressive Year for Stocks of All Sizes
Russell Index Returns, 12/31/25-12/31/25

Past performance is no guarantee of future results

The question that this letter seeks to answer, of course, is how and when might small-caps join their micro-cap siblings at the market’s performance summit?

AI: Coming Soon to a Small-Cap Company Near You?

One path involves shifts in terms of which companies appear likely to benefit from the AI revolution in 2026. To quote Mark Twain (as well as to echo how most of our investment teams view their technology investments), “During the gold rush, it’s a good time to be in the pick and shovel business.” The Magnificent 7 group of mega-cap companies have been generating headlines almost every day about the billions of dollars they or their ecosystem partners have raised to fund continued investment in AI models, computing power, data center capacity, etc.

We own companies that have already been reaping the benefits of this spending since they provide differentiated products or services that are key enablers of AI’s evolution and the buildout of AI-related infrastructure. These companies are supplying many of the tools, components, and services to their bigger peers, including semiconductor components that enable various AI applications, energy providers crucial to the functioning of data centers, and the construction companies that are building them. A few examples include: A duopoly provider of advanced probe cards that are essential for testing complex high bandwidth memory chips and GPUs; a critical infrastructure products producer that is a dominant provider of the highly engineered utility structures needed for utilities to harden their grids and expand higher voltage transmission in the face of rising load growth (in part from AI data centers); a specialty infrastructure services provider that is the scale player in site preparation for data centers and semiconductor fabs; and a premier engineering and consulting firm that brings domain expertise to clients incorporating machine learning and AI into their systems and products, while also helping to address potential challenges and disputes that may arise. In something of a paradox, then, smaller companies that are helping mega-cap players are getting on investors’ radar just as we are beginning to see a so far gradual unwinding of the AI trade, which is lowering share prices for certain mega-cap companies.

There is another set of small-cap companies that are using AI to drive innovation, productivity, and/or efficiency. We anticipate a more pronounced shift away from some of the mega-cap companies that provide AI to the many companies that can commercialize AI applications to grow their businesses and/or companies that will see margin improvement by leveraging AI tools. Active management will likely be critical in sourcing the smaller companies that stand to do best in what is shaping up to be a vigorous, though at times highly volatile, market this year (as a few sessions in early January have shown). There are also a number of consulting companies and software businesses that have been virtually left for dead. However, our conversations with management teams and further research and analysis suggests these companies should actually benefit from AI and are likely to see improved profitability in the years ahead. We’ve seen a similar dynamic before within small-cap, where pockets of the market have been beaten down before other investors realize that these companies are well positioned to benefit from a new technology, leading the stocks to rebound nicely.

Small-Cap Opportunities Beyond AI

Of course, our investment teams see many opportunities in areas that lie outside AI, including businesses in the Consumer Discretionary and Consumer Staples sectors. There have also been interesting opportunities in Health Care beyond the biopharma complex, which dominated small-cap performance in 2025. Elsewhere, they have been investing in industries such as packaging, business services, and insurance, all of which appear poised to do well in 2026. Green shoots can be seen in the non-AI parts of the semiconductor chain, along with companies involved in manufacturing, where industrial distributors, to take one example, are starting to experience stabilization at the bottom of the business cycle. Opportunities have also been found in diverse areas such as commercial and professional services, transportation, and capital markets.

Even as many small- and micro-cap companies have done well over the last nine months, the breadth and depth of the universe—in addition to the much lower level of analyst coverage—help make our selection universe an evergreen source of investable ideas.

Revenge of the Forgotten Asset Classes?

After more than a decade of underperformance, we have taken to referring to small-cap as “the forgotten asset class.” If that is the case, then micro-caps would qualify as the really forgotten asset class. Thus far in 2026, for example, the financial media has paid almost no attention to the extraordinary run for micro-caps last year. Also receiving very little attention has been how well both small- and micro-caps performed from the April 2025 bottom into January of 2026. From 4/8/25-1/23/26, the Russell Microcap gained 81.5%, the Russell 2000 advanced 56.0%, the Russell 1000 was up 40.3%, and the Russell Top 50 advanced 43.6%.

Small- and Micro-Cap’s Impressive Runs Off the April Market Low
Russell Index Returns, 4/8/25-1/23/26

Past performance is no guarantee of future results

We are confident that this run can continue. After years of false starts, head fakes, and rallies that began with promise only to end with small- and micro-cap stocks trailing their larger counterparts, we understand—and share—the frustration that comes with extended periods of underperformance. First, it’s important to keep in mind that 2025’s returns, particularly off the April lows, were driven primarily by lower quality, speculative stocks, along with anything with an obvious connection to the AI boom. Low quality small-cap cycles tend to average about 12 months, suggesting that a regime shift is likely in the next few months. Additionally, more of what we would characterize as “traditional” businesses models—those that have healthy margins, generate free cash flow, grow modestly, and have strong, self-funding balance sheets that also trade at attractive valuations—should regain the attention and interest of investors as many of the early phase winners begin to fall back.

With regard to micro-caps specifically, returns for the asset class are often a barometer of risk. To the extent that investors remain comfortable with less liquidity and are willing to take risks, micro-caps should do well. Equally important, there are higher-quality micro-cap companies, and if the market continues to broaden out as we expect, more of these micro-caps should participate as the leadership baton within small-cap as a whole passes from more speculative stocks to more established, quality companies with more proven, durable business models.

Why Small-Cap, Why Now

There are additional factors that can drive both strong returns and overall market leadership beyond what we have already discussed. For the purposes of this discussion, we include micro-caps within the broad and diverse small-cap universe. First, one of the more interesting elements in the “Big, Beautiful Bill” signed earlier this year is the fact that companies can have 100% depreciation on research and CapEx—which suggests that we could see a robust CapEx cycle in 2026. Such cycles have typically meant good things for small-cap stocks, though the market has not yet caught on to this. We expect that to change as the year progresses.

We also believe that both small-cap quality and value are poised for meaningful rebounds in 2026. The most likely path to outperformance would be one in which economic growth accelerates, in part driven by stimulus coming from Washington that could help both businesses and consumers, particularly those in the lower half of income distribution. If this occurs, more widespread economic growth would benefit a broader array of industries from banks (thanks to loan growth and healthy credit) to select areas in Industrials (due to onshoring and solid general growth) and Consumer Discretionary. Previous periods that had more widespread equity returns (in stark contrast to the unprecedented narrow market leadership of the last few years) have seen small-caps beat large-caps most of the time, often by healthy margins. Of course, we are mindful that narratives, as well as fundamentals, can shift quickly and unexpectedly—and we are prepared to capitalize on opportunities regardless of the macroeconomic backdrop.

Do Earnings + Valuations = Sustained Small-Cap Leadership?

In our view, by far the most compelling case for small-cap leadership in 2026 comes from a relatively rare and promising confluence of factors: Relatively low valuations for small-cap versus large-cap and the forecast for higher earnings for small-cap companies. Even after a year of robust returns, valuations for the Russell 2000 at the end of 2025 were still quite close to their lowest levels versus the Russell 1000 in 25 years, using our preferred index valuation metric of EV/EBIT or enterprise value over earnings before interest and taxes.

Relative Valuations for Small-Caps vs. Large-Caps Remain Near Their Lowest in 25 Years
Russell 2000 vs. Russell 1000 Median LTM EV/EBIT (ex. Negative EBIT Companies), 12/31/00 through 12/31/25

Source: FactSet

But the argument in favor of small-cap leadership is greatly enhanced by the promising earnings picture for 2026. We have always subscribed to the adage that psychology runs the market in the short run, but earnings run it in the long run. Earnings for across asset classes were generally positive in 3Q25, with many companies handily beating estimates. Smaller companies, however, generally fared better in terms of earnings growth. Even more encouraging, the research we have seen forecasts accelerated earnings growth for small-cap stocks in 2026. The rate cuts provided a boost, while additional catalysts, including possible tariff relief, reshoring, and ongoing infrastructure improvements, should also help vault small-caps into a sustained leadership role, as can the aforementioned possibility of a healthy CapEx cycle and the benefits accruing to those small-cap companies that are providing AI’s ‘picks & shovels.’

Small-Cap’s Estimated Earnings Growth is Expected to Be Higher Than Large-Cap’s in 2026
One-Year EPS Growth

Past performance is not guarantee of future results.
Earnings per share (EPS) is calculated as a company’s profit divided by the outstanding shares of its common stock. The EPS Growth Estimates are the pre-calculated mean two-year EPS growth rate estimates by brokerage analysts. Estimates are the average of those provided by analysts working for brokerage firms who provide research coverage on each individual security as reported by FactSet. All non-equity securities, investment companies, and companies without brokerage analyst coverage are excluded. Source: FactSet.

We enter 2026 with ample levels of uncertainty for both the U.S. economy and on the geopolitical front. Yet our investment teams remain confident that small-cap can attain and sustain market leadership. Finally, we want to remind investors that the opportunity still exists to build one’s small-cap allocation at attractive valuations. We continue to see the current period as an opportune time to invest in select small-caps for the long run.

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