American small caps (firms with market capitalisations of up to $2 billion, although some would include companies worth as much as $10 billon) have traditionally been seen as the best place for investors seeking high long-term returns. They have outperformed large caps since 2000, says Jan Willem Berghuis of Van Lanschot Kempen. Over the past 15 years, however, the small fry have fallen from favour and are “struggling” to match the performance of their larger counterparts, says Freddy Colquhoun of JM Finn. The good news is that economic headwinds are abating and the end of uncertainty over the election is already providing a short-term boost. And as the frenzy around large-cap tech stocks cools, the depth and breadth of the US small-cap market will make it look particularly attractive in the longer term.
Why have US small caps underperformed?
One reason for the recent poor performance by US small caps is that they tend to be more vulnerable to negative shocks to the economy, such as the rise in inflation. The subsequent rise in interest rates particularly hurt a sector that tends to “borrow more and need more regular refinancing”, as Oren Shiran of the Lazard US Small Cap Equity fund points out. Seventy per cent of small-cap debt is coming due for repayment in the next five years, compared with 45% for large-cap debt, says Shiran, and 40% of the debt that small-cap firms hold is on variable rates, compared with only 5% for large caps.
Small caps are also particularly vulnerable to talk of a “hard landing” or a recession in the US, says Alex Knox, co-manager of Premier Miton’s US Smaller Companies and US Opportunities funds. Small caps get around 70%-80% of their revenue from the US, compared with around half for the stocks that make up the S&P 500, “which really isn’t a US index anymore”. So they should be less exposed to ructions in global trade as a result of Donald Trump’s protectionism. In fact, many of the headwinds that have held small caps back are “becoming tailwinds that could push them forwards”, says Knox.
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The US Federal Reserve has started to cut interest rates – the base rate is now down by 0.75 percentage points from its peak – and “research suggests that small caps tend to do better during a rate-cutting cycle”. Indeed, the start of a rate-cutting cycle may be one of the reasons small caps have started to “normalise”, performing better than large caps since June. Knox believes fears of a recession are abating and that expectations are shifting towards anticipating a soft economic landing, especially as the US consumer “seems to be in relatively good shape”.
Small caps are Trump trades
Over the past few months, worries about the presidential election, especially over what would happen if Trump lost but refused to accept the result, had been weighing on the sector – “markets don’t like uncertainty”, as Knox says. But with the election now out of the way, and concluded without the disputes and legal battles that many had been dreading, this cloud will now be lifted, leaving small caps space to power ahead. Trump’s victory also removes the risk of US corporate taxes rising from 21% to 28%, something the Democrats had been pushing for, says Dan Squires of Saxo. Such a move would have led to a “swift, one-off negative adjustment” in the prices of US shares, especially those that make their money domestically. As it is, small caps look particularly well placed to benefit from Trump’s proposed programme of tax cuts and deregulation, especially as Republicans managed a “clean sweep” and take the House of Representatives as well as the Senate and White House, says Colquhoun. And it remains to be seen whether Trump will really impose the blanket tariffs he promised on the campaign trail. Colquhoun thinks that fears on this score are overdone.
Indeed, small caps could actually benefit if the US imposes some additional trade barriers in certain sectors, says Mark Ellis of the Nutshell Growth Fund. Tariffs may push up prices for larger firms and for the consumer, and invite retaliation from America’s trading partners, but that would just make goods produced by domestic companies more attractive. After a period in which “large companies have enjoyed the benefits of increasing globalisation”, the “pendulum has already begun to swing in the other direction”, and “many companies in the US have begun to move production back to the shores of the US”, says Matt Mahon of T. Rowe Price. This has created a “unique opportunity” for smaller, US-focused companies to gain from the “resulting job creation, infrastructure development and economic stimulus driven by these long-term capital inflows”, says William Blair Investment Management’s Rob Lanphier.
Were Trump to blunder in his second term, there’s still a limit to how badly things can go, says Chris Metcalfe of IBOSS, part of Kingswood Group – “fiscal and monetary support” is always likely to be forthcoming “at the first sign of trouble, which seems to have become the new playbook for the US, as well as many other countries around the world”.
Why small caps look stunningly attractive
Even if the economic situation ends up being a little bumpier than expected, or Trump’s policies backfire badly, that doesn’t mean US small caps will necessarily suffer. Small caps are valued in such a way that the US economy “doesn’t have to be stunningly amazing for them to do well, just not completely dire”, says Mark Sherlock of Federated Hermes. Indeed, “even though small caps have cumulatively lagged the market since 2011, they have actually grown their earnings faster than the S&P 500”, as Brett Reiner of the Neuberger Berman US Small Cap fund points out. Smaller companies now look “stunningly attractive”, especially when compared with the valuations of larger companies, agrees Sven Anders of JPMorgan.
The forward price/earnings ratio of the Russell 2000 (one of the main small-cap indices) has historically traded at an average forward premium of around 30% to that of the S&P 500, to account for the superior growth potential of smaller companies. Right now, however, the two are trading at similar levels – and, according to other measures, the small-cap index is actually now at a slight discount to the S&P 500.
Another indicator that small caps are good value is that the S&P 500 is heavily concentrated, with just five companies (Apple, Microsoft, Amazon, Google/Alphabet and Nvidia) accounting for around 30% of the market. Just as high levels of market concentration (although on a much smaller scale than today) in the early 1970s and at the height of the tech boom in 2000 were followed by a period where smaller shares did much better, today’s high concentration levels are a bullish sign for small caps, says Anders.
Indeed, one of the reasons small caps have lagged the market is not so much that they have performed particularly badly, but that tech firms have done so well. This trend picked up pace in the last few years thanks to the “halo effect of association with artificial intelligence that has driven up the share prices of the Magnificent Seven”, says Mike Coop of Morningstar Wealth. The strong performance of these tech stocks – Alphabet, Amazon, Apple, Meta Platforms, Microsoft, Nvidia and Tesla – has “shifted investors’ attention from smaller companies”, making their growth prospects seem “less attractive”, says Nefeli Neophytou of Arbuthnot Latham.
But just because we’re living through an “exceptional and unusual time” in some ways doesn’t mean that things will automatically revert to “normal”, says Andrew Holliman of Polar Capital. Still, the “law of large numbers” does suggest that the “exceptional operating performance” of the big names will have to come to an end at some point, “not least due to the growing regulatory risks, as well as the need for ever higher levels of capital spending to maintain their position”. There may be no guarantees that the relative position of small and large caps will change, but “the risk/reward balance favours the former”, says Reiner.
Buy quality small caps
Just because smaller caps in general look attractive, that doesn’t, of course, mean that each individual company is worth buying. “As with any given sector, there are some small-cap firms that are attractive and others that you should avoid,” says Holliman. There are “some great small businesses” out there, but investors should beware buying into what he terms “zombie companies” – those with low profitability and especially high levels of debt, which may look cheap now, but “will struggle to survive in the longer run”.
Investors should focus instead on those companies that are not only profitable at the moment, but will have “room and ability to compound their earnings, so that they will be much bigger in five to 10 years’ time”, says Holliman. Smaller companies tend to be more indebted than larger companies, so making sure that the balance sheet is strong, and that debt levels are manageable, is important for identifying likely survivors. Companies that take on too high a level of debt could end up being wiped out by a sudden shift in the economic cycle, or by an unexpected shock.
Quality companies “have always done well in the medium term”, agrees Sherlock. Investors should think about whether the small-cap companies they are considering buying are generating a consistent amount of cash. Barriers to entry that prevent competitors coming in and pushing down margins or stealing business outright are another thing to look out for. In Sherlock’s experience, the most successful small-cap firms are those that “inhabit a niche area that is big enough to be profitable and enjoy opportunities for growth, but too small for the big companies to be bothered with”.
Choose S&P 600, industrials and biotech
The importance of quality in finding successful small caps is one reason why Sherlock uses the S&P SmallCap 600 (S&P 600) as his preferred small-cap index, rather than the Russell 2000. Both indices cover small companies, but the way that the S&P 600 is selected means that the companies in it tend to be on a much firmer foundation than those in the Russell 2000. Around half the firms in the latter index “aren’t making a profit at the moment”, he notes. These companies may benefit more from falling interest rates in the very short run, but those in the S&P 600 have “better long-term prospects as they are in control of their destinies”.
Dan Boardman-Weston of BRI Wealth Management agrees that the S&P 600 is the more attractive small-cap index. In terms of specific sectors, he likes industrials and thinks that some of the smaller US property companies and real estate investment trusts (Reits) are worth looking at, especially those that deal with industrial property (warehouses, workshops and factories), rather than shopping centres or offices. Small technology companies are another area worth investigating.
But by far Boardman-Weston’s favourite part of the small-cap market is biotechnology. Investors do, of course, have to be “highly selective” when they invest in this area as so much depends on the success of individual drugs and treatments. Boardman Weston notes that biotech valuations have “collapsed” over the past two years, with the sector becoming so unfashionable that “many small biotech companies are now trading below the cash on their balance sheets”. He thinks that this is a mistake as artificial intelligence “will help drug discovery” as well as speed up the development of “treatments that are tailored to the individual patient”.
The US small-cap sector is so large that taken together “it would be one of the top-10 markets in the world with a similar market cap to the FTSE”, says Reiner. Investors who do their homework should “be able to find plenty of good firms that can grow through a market cycle”.
How to invest in US small caps
The easiest way to invest in US small-cap shares is through an exchange-traded fund (ETF) that tracks either one of the two major small-cap indices. The iShares S&P SmallCap 600 Ucits ETF Acc (LSE: ISP6) tracks the S&P 600, which includes companies with a median market capitalisation of $1.74 billion, and has a trailing price/earnings (p/e) ratio of 16.8. The ETF has a total expense ratio of 0.3%. Alternatively, the Invesco Russell 2000 Ucits ETF Acc (LSE: RTYS) tracks the Russell 2000 index, which has a median market cap of just under $1 billion and an average p/e (excluding negative earnings) of 18.31. The total expense ratio is 0.25%.
One active fund to consider is the Premier Miton US Smaller Companies fund. It is a genuine small-cap fund, investing in companies with a market cap of between $100 million and $6 billion at the time of purchase. It also has a strong record, with a total return of 61.10% since its inception in March 2018, compared with 55.5% for the Russell 2000. The basic strategy is to “buy attractive companies and hold them for the medium term”, says Alex Knox, who manages the fund with Hugh Grieves. The fund uses screening tools and research to come up with a list of attractive companies, which it then buys when they become cheap enough. Its largest holdings include Carpenter Technology, OneSpaWorld Holdings and H.B. Fuller. The ongoing charge is 1.03%.
Another actively managed fund that looks attractive is the Neuberger Berman US Small Cap Fund Ucits. Run by experienced managers Robert D’Alelio, Brett Reiner and Gregory Spiegel, it focuses on “high quality, small-cap firms in growing markets with conservative balance sheets that are able to generate significant amounts of free cash flow and a good return on capital”, says Reiner. The team also look for “durable advantages over time, such as intellectual property”. Since its inception in July 2011, it’s beaten the Russell 2000, its benchmark, by around 1.2% a year. The ongoing charge is 0.99%.
Reiner is particularly bullish about Kirby (NYSE: KEX), his fund’s third-largest holding. Although at the larger end of the small-cap spectrum, with a market cap of $7.35 billion, the Houston-based company is the largest inland barge-fleet operator in the US. It has “meaningful scale, very strong operational standards and a reputation for a high level of safety”. It has also been able to acquire other companies in the same area, giving it pricing power, especially at a time when the supply of barges is quite tight. It is a prime example of a small company in a “boring industry” that is consistently able to grow its business through economic cycles. Kirby trades at 18.7 times 2025 earnings.
The JPMorgan US Smaller Companies Investment Trust (LSE: JUSC) also looks interesting. It aims to blend growth and value investing, looking for “good-quality companies with good management teams that benefit from barriers to entry and have good relations with suppliers and customers”, says Sven Anders of JPMorgan. The trust has beaten the benchmark Russell 2000 over the past 10 years, has an ongoing charge of 0.93% and trades at just under a 10% discount to its net asset value. One of its top-10 holdings is MSA Safety (NYSE: MSA), with a market cap of $6.8 billion, which makes safety products, such as helmets and fire equipment. MSA has long-standing contracts with various US government agencies who need to replace their equipment regularly to comply with regulations, “giving MSA a good cash flow”, says Anders. It trades at 21.4 times 2025 earnings.
This article was first published in MoneyWeek’s magazine. Enjoy exclusive early access to news, opinion and analysis from our team of financial experts with a MoneyWeek subscription.
