Small-Cap Stocks May Be Ready for a Turnaround

For quite some time, small-cap stocks haven’t really lived up to their high expectations, particularly in terms of outperformance during positive market conditions.

However, analysts suggest that this might soon change, with smaller firms projected to experience quicker revenue growth than their larger counterparts. Additionally, their relatively low valuations could spark a flurry of corporate mergers and acquisitions to further energize the sector.

According to Hugo Stemary, a strategist at Scotiabank, third-quarter earnings for small and medium-sized companies in the S&P 600 index are anticipated to rise by 14%, surpassing the S&P 500’s growth of nearly 12%. This trend is expected to persist.

Chris Tessin, chief investment officer at Aquitas Investments, believes that further cuts in interest rates could enhance earnings for smaller firms, which generally carry heavier debt loads. For investors seeking outperformance in 2026, small companies might be positioned to deliver. He noted that the difference in valuation and growth profiles is significant; eventually, investors will likely return to small-cap stocks, given their superior earnings growth potential compared to large-cap stocks.

“I don’t think the situation has evolved so drastically that larger firms will always have the upper hand,” Tessin remarked. He posed a thought-provoking question: “Can you truly say a sequoia will always outgrow a sapling?”

The potential for increased corporate deal-making could lend support to smaller companies, especially since years of stagnant share price growth have made some of these companies look pretty appealing, particularly when compared to larger firms. The underperformance seen since 2022 is still developing, with Scotiabank analysts highlighting the current valuation gap as the most significant in four decades.

The Russell 2000 index has risen by 10% this year, while the S&P 500 has gained 17% and the Nasdaq 100 has increased by 21%. Looking back to the end of 2022, the disparity becomes even more apparent; the S&P 500 nearly doubled the Russell index’s approximately 40% gain.

This performance gap has led to small-cap stocks being considered “historically undervalued.” Furthermore, mergers and acquisitions in the sector seem to be on track to hit their highest levels in decades, according to a note from BofA Securities.

Tessin expressed this sentiment vividly, saying, “You could drive a truck through the return differential.”

Despite this, investors have been pulling money from the small-cap sector throughout the year, with net outflows from the iShares Core S&P Small Cap ETF occurring in all but two months of 2025. Moreover, the rate of merger and acquisition activity among Russell 3000 firms is on pace to match the record set in 1996, with significant acquisition premiums often being favorable for small-cap performance, as noted by Stephen DeSanctis from Jefferies. “The animal spirit is back in many M&A deals,” he observed.

That said, the anticipated rapid turnaround for small-cap stocks isn’t universally agreed upon. Ed Clissold, chief U.S. strategist at Ned Davis Research, pointed out that while small-cap stocks are indeed undervalued in relation to large-cap stocks, a catalyst to trigger movement is currently absent. He added that investors might need to wait a few years for these smaller companies to actually outshine their larger rivals, especially during recovery periods following recessions.

“It’s a critical time for valuations. If someone wants to start investing in small-cap stocks, that’s reasonable, but be prepared that it may take some time for this strategy to yield results,” Clissold advised.