A Turning Point for Small-cap Equities?

After several years of underperformance, small and mid-capitalization equities (collectively, SMID-caps) are beginning to attract renewed attention. Relative valuations, shifting economic conditions, and improving earnings expectations suggest that a more balanced view may be warranted between large and small companies in portfolios. Despite the risks, including economic policy uncertainty, monetary and fiscal policy direction, and trade tensions, the current environment may present a compelling case for SMID-caps to regain relevance within investment portfolios.

Recent Large-cap Dominance

Over the last decade, large-cap stocks, especially the “Magnificent 7” (Mag 7), have significantly outpaced most asset classes, including SMID-cap equities. This outperformance has reflected fundamental earnings growth and multiple expansion amid technological innovation, and strong consumer demand.

However, by historical standards, this outperformance has led to stretched valuations, especially for companies at the upper end of the size spectrum. For example, as of March 31, 2025, the S&P 500 forward price-to-earnings (P/E) ratio stood at 20.2x, approximately one standard deviation above its 25-year average of 16.8x. Meanwhile, SMID-cap equities have lagged, weighed down by tighter financial conditions, greater exposure to economic cyclicality, and higher sensitivity to interest rates.

Looking at the past, market leadership often shifts. In fact, several indicators today point to a favorable environment for SMID-cap equities. These companies, which are more economically sensitive and domestically focused both in terms of revenue and supply chain, could be on the cusp of reclaiming leadership in the face of moderating inflation, the potential for easing monetary policy, and a possible recovery in domestic economic activity.

The Proxies: Russell 1000 vs. Russell 2000

The Russell 1000 Index comprises the largest 1,000 U.S. companies by market capitalization, capturing roughly 93% of the total U.S. equity market. By contrast, the Russell 2000 Index represents the next 2,000 companies by market cap. As a result, the most immediate difference between the two indexes lies in size.

As of March 31, 2025, the median market cap for a security in the Russell 1000 was approximately $13.4B, compared to a median market cap of $0.7B for the Russell 2000. However, the differences become even wider when looking at the weighted average market capitalization. The Russell 1000's average market cap was approximately $841B, while the Russell 2000's stood at roughly $3.4B. The massive skew highlights the concentration risk embedded within the large-cap universe. Due to this skewness, within the Russell 1000, a small number of very large companies disproportionately drive overall index performance. For example, at present the 10 largest holdings in the Russell 1000 make up roughly 33% of the index. SMID-caps, by comparison, offer a more diversified exposure across a broader range of company sizes, with the top 10 holdings making up less than 5% of the total index.

Beyond size, the sector composition for each index differs significantly, shaping both performance drivers and risk exposures. Technology and Communication Services dominate in large-caps. Tech accounts for approximately 30% of the Russell 1000 index, reflecting the concentration of mega cap growth names, including many of the Mag 7 names that have led market performance in recent years. Communication Services (~9%), driven by companies like Meta Platforms and Alphabet (also in the Mag 7), add to the tech-oriented tilt in the large-cap index.

These tech sector companies, particularly those in the Mag 7, have secular growth characteristics, indicating greater resilience to economic cycles. For example, innovation, cloud adoption, and AI investment drive Apple, Microsoft, and NVIDIA's performance. These reflect secular demand drivers less timed to immediate GDP growth or economic expansions/contractions.

In contrast, SMID-caps are heavily weighted towards Industrials and Financials, representing nearly 40% of the Russell 2000 Index. These sectors tend to expand faster when the economy grows (GDP rises) and may contract harder during recessions or slowdowns. Healthcare (~16.5%), particularly biotechnology and specialized medical equipment companies, is another significant weight within small-caps. In comparison to the Russell 1000, Tech represents only ~13% of the Russell 2000, significantly reducing the index's direct exposure to the secular growth drivers that have benefited large-caps but potentially increasing its sensitivity to broader cyclical trends.

Another critical difference between the two indexes is the degree of international revenue exposure. This difference is particularly relevant as the U.S. continues to move away from the globalization trends of the last few decades. The S&P 500 companies generate approximately 40% of their revenue from international markets, with the Mag 7 even more exposed at 53%. In contrast, the Russell 2000 companies derive most of their revenue – nearly 80% - from domestic U.S. sources. The exhibit below shows that roughly 70% of the Russell 2000 index earns more than 72% of their revenue from the U.S., compared to only 31.4% for the Russell 1000.

This domestic concentration can be a double-edged sword. While domestic reliance can insulate SMID-caps from global economic volatility, it also ties their fortunes more directly to the strength or weakness of the U.S. economy.

Finally, there is a significant difference in the quality of earnings and profitability across the two indexes. As of March 31, 2025, approximately 92% of the Russell 1000 companies were profitable on a trailing 12-month basis compared to only 60% of Russell 2000 companies. Though SMID-caps may offer higher growth potential, they also tend to come with greater earnings volatility and financial leverage. This difference highlights a greater operational risk within SMID-caps compared to large-caps.

A Growing Divergence

Over the past decade, the relative valuations between large-cap and SMID-cap equities have diverged. Today, the valuation gap stands at one of the widest levels seen in the past two decades, creating an opportunity for investors willing to look beyond near-term macro uncertainty.

As of March 31, 2025, valuation metrics highlight the gap between large and SMID-cap equities. Specifically, the S&P 500 trades at a forward P/E ratio of 20.2x, well above its historical average. The S&P 1000 (a combination of the S&P MidCap 400 & S&P SmallCap 600 Index), by contrast, trades at a forward P/E of 14.4x.

Additionally, large-caps are trading 26.6% above their 20-year historical average forward P/E, while SMID-caps are trading only 4.2% above their historical average. This relative discount is rare. Historically, SMID-caps have traded at a modest premium to large-caps because of their higher expected growth rates. Today, the relationship has inverted, suggesting Small-caps may be undervalued relative to their history and large-cap peers.

Another key aspect of the valuation story is forward earnings growth. Based on FactSet consensus estimates, Russell 1000 companies are expected to deliver 14% earnings growth in 2025, compared to Russell 2000 companies, which are projected to produce a 44% earnings growth.

The drivers of the SMID-cap earnings growth include the recovery in the cyclically sensitive sectors, such as Industrials, Financials, and Consumer Discretionary, as well as easier year-over-year (YoY) comparisons following earnings compressions during the 2022 – 2023 period. Further, inflation pressures on labor, shipping, and raw materials (e.g., energy and metals) have eased significantly from 2022 – 2023 peaks. This reduction in inflation pressure is evidenced by lower YoY producer price index (PPI) readings, normalized freight rates (as seen by the Baltic Dry Index), and a cooling, though elevated, wage inflation. Moreover, nominal revenue growth has remained resilient in many sectors, particularly in sectors where the Russell 2000 is overweight. Margins are beginning to stabilize as input cost pressures ease and revenue growth improves.

Finally, a defining characteristic of the SMID-cap universe is the extremely high dispersion between the strongest and weakest companies.

Profitability, balance sheet strength, and earnings visibility vary dramatically across Russell 2000 constituents. As a result, "quality" small-caps (i.e., profitable companies with strong free cash flow generation) are trading at attractive absolute and relative valuations. In contrast, speculative or unprofitable small-caps remain highly sensitive to financing conditions and market sentiment shifts.

Why Small-caps May Be Positioned to Outperform

While small-cap equities have faced significant headwinds in recent years and macroeconomic risks remain elevated, several dynamics suggest that SMID-caps may be increasingly well-positioned for relative outperformance should economic conditions stabilize or improve over the coming cycle.

Historically, SMID-cap equities have tended to outperform large-caps in the early stages of economic recovery and periods of monetary easing. Following periods of aggressive tightening by the Federal Reserve (Fed), as financial conditions begin to normalize and liquidity returns to the system, smaller companies, often more tied to domestic economic activity and earlier in their growth lifecycles, have typically rebounded more strongly.

Rather than assuming a recovery, it is important to recognize that current valuations, earnings growth potential, and sector composition create an asymmetrically favorable setup for patient and selective investors.

While today’s market environment has its own unique dynamics, history offers valuable perspective. Small-caps notably outperformed large-caps from 1975 to 1983, despite high inflation, volatile growth, and rising rates. This outperformance was driven by deep valuation discounts, pricing agility among niche domestic firms, and favorable liquidity conditions. Though volatile, the period demonstrated how valuation dislocations and cyclical recoveries can create strong setups for SMID-cap leadership even amid uncertainty.

Additionally, in the early 2000s recovery, following the dot-com bubble and Fed rate cuts, small-caps meaningfully outpaced large-caps over a multi-year stretch. Later, in the post-Global Financial Crisis (GFC) recovery, the Russell 2000 outperformed the Russell 1000 significantly for several consecutive years as the monetary policy remained accommodative and economic growth stabilized.

While no historical pattern guarantees future results, these periods suggest that improved liquidity, declining borrowing costs, and renewed economic growth create a favorable environment for small-caps.

As detailed earlier, small-caps are trading at a rare valuation discount to large-caps, both relative to historical norms and on an absolute basis when adjusting for profitability. Forward P/E multiples for small-caps are significantly closer to their long-term averages than large-caps, which continue to trade well above historical norms despite recent market volatility. This discount reflects substantial market pessimism already priced into small-cap equities. Historically, when small-caps have traded at such discounts, subsequent periods have often produced attractive relative returns, not necessarily because conditions were perfect but because expectations had already been deeply discounted.

While the timing of such reversion is uncertain, today's depressed valuations and stronger forward growth estimates improve the odds of a more favorable relative cycle for small-caps over the medium term.

Risks to Monitor

While the current valuation and earnings landscape for SMID-cap equities presents an increasingly attractive opportunity, meaningful risks persist. Such challenges include 1) macroeconomic uncertainty, 2) rising tariff and trade tensions, 3) a higher proportion of unprofitable companies, 4) financial conditions and credit access, and 5) ongoing volatility and sentiment swings.

Despite the positive signs described earlier, the macroeconomic outlook remains questionable. Concerns about a potential U.S. recession, persistently restrictive monetary policy, and renewed credit tightening continue to weigh on sentiment. Given their higher economic sensitivity, SMID-cap companies could face greater earnings pressure in a downturn relative to large-cap peers.

Additionally, a growing focus on tariffs represents an ongoing headwind. New or expanded tariffs could reignite supply chain costs, reversing some recent stabilization in margins. Although SMID-caps are more domestically focused than large-caps, many still depend on imported inputs, exposing them indirectly to rising costs. Policy-driven disruptions could exacerbate volatility and challenge SMID-cap profit margins.

Moreover, while SMID-caps offer attractive aggregate earnings growth potential, the quality of earnings across the universe remains highly dispersed. This wide dispersion highlights the importance of maintaining some exposure to active management, as opposed to relying on a purely passive strategy, within the SMID-cap segment.

Due to their smaller cash flows and less established balance sheets, SMID-cap companies generally rely more on external financing than large-cap companies. Tightening credit standards through higher interest rates or reduced lending appetite can materially impact SMID-cap capital access. This dynamic increases the risk of operational stress and potential earnings downgrades for weaker companies.

Finally, even if the longer-term case for SMID-caps strengthens, shorter-term volatility could remain elevated. Investor sentiment toward smaller companies tends to be highly procyclical, meaning that Small-caps often experience sharper drawdowns during risk-off periods. Shifting Fed expectations, geopolitical tensions, and negative surprises on growth or inflation could trigger periods of heightened volatility, testing investors' patience and risk tolerance.

Conclusion

Admist recent underperformance and a challenging macro backdrop, SMID-cap equities are increasingly positioned to offer interesting long-term opportunities. Today’s environment presents a rare combination of depressed valuations, improving forward earnings potential, and cyclical sector exposure that could favor SMID-caps should economic conditions stabilize or recover.

Historically, SMID-caps have tended to lead during early-stage recoveries and monetary easing cycles. While the path forward remains uncertain, the asymmetric opportunity they present makes them a valuable complement to traditional large-cap exposure within diversified portfolios. However, elevated macro risks and wide dispersion in fundamentals suggest that purely passive exposure may fall short both in capturing upside and managing risk.

At Fire Capital Management, navigating this environment requires a disciplined, research-driven approach focused on identifying profitable, fundamentally strong companies with sustainable growth prospects, managing risk proactively amid a shifting macroeconomic and policy landscape, and maintaining a long-term perspective grounded in empirical evidence and valuation discipline. SMID-caps may not offer a smooth ride, but for those prepared to endure volatility, they represent a possible ripe opportunity.