Key Takeaways:
Small-cap stocks are positioned for an extended period of outperformance as the rotation from mega-cap growth accelerates, according to Royce Investments.
Small-cap stocks will remain in a sweet spot for quite some time as the rotation from mega-cap growth names broadens out, Francis Gannon, co-CIO at Royce Investments, said.
"The small-cap space has turned around, and we think it's going to be in a sweet spot for quite some time," Gannon said Monday on CNBC's "Power Lunch." Valuations remain attractive relative to large caps, and the economic backdrop supports smaller companies, he said.
The Russell 2000 surged 21.49% in the second quarter, its strongest quarterly gain since 2020, while the Russell 2000 Value Index advanced 17.19%. The S&P SmallCap 600 has delivered a 36.9% trailing 12-month total return through June 26, according to State Street data. Ariel Investments' Small Cap Value composite gained 17.19% gross of fees in the quarter, in line with its benchmark.
The call comes as investors rotate from mega-cap technology names into smaller companies, a shift that could broaden the equity rally and reduce the market's reliance on a handful of stocks. The Russell 2000's Q2 gain outpaced the S&P 500's advance during the same period, as easing geopolitical tensions, lower oil prices and resilient corporate earnings supported the move into riskier assets.
Why small caps now
Small-cap stocks offer several structural advantages in the current environment, according to Gannon. Smaller companies are typically better positioned to respond quickly to changing market conditions and capitalize on emerging opportunities, without the bureaucratic layers that slow decision-making at larger corporations.
The sector also benefits from merger and acquisition activity, as larger companies target small caps to expand market presence. When a larger company acquires a small-cap company, existing shareholders can benefit from improved liquidity and takeover premiums.
Valuation and growth potential
Despite the recent rally, small-cap valuations remain below historical averages relative to large caps, Gannon said. The Russell 2000 trades at a discount to the S&P 500 on a forward price-to-earnings basis, a gap that typically narrows during economic expansions.
Small caps also offer higher growth potential due to their earlier stage of development and greater room for expansion. These companies often operate in niche markets with innovative products or business models, creating opportunities for rapid stock price appreciation that larger, more mature companies cannot match.
However, Gannon cautioned that small caps carry higher risk. They tend to be less diversified, more sensitive to economic cycles and interest rates, and more reliant on external financing. The higher failure rate and greater volatility are precisely why investors expect higher returns for accepting these risks, he said.
This article is for informational purposes only and does not constitute investment advice.
