Small Caps Aren't Dead — They're Misunderstood - Quent Capital - Commentaries

Small-cap stocks have provided a return pattern quite different from large-cap stocks. Typically, small caps either race ahead of larger companies or else fall behind. They’re rarely in synch.

People explain the long-term outperformance in many different ways:

Smaller firms have more risk
Smaller firms are more illiquid
Investors have more confidence in, or knowledge about, larger firms, driving their prices up and returns down
Smaller firms are less closely followed by analysts and the market for them is less efficient

However, the cyclicality or lack of synchrony between large- and small-cap stocks makes it hard to exploit this premium. While the Fama-French small cap index outperformed the S&P 500 by a healthy 1.04% per year compounded from July 1926-June 2025, resulting in 2-1/2 times as much (see Exhibit 1) ending wealth over nearly a century, this outperformance has been so inconsistent that small-cap investors can experience very long periods of drawdown relative to large-cap benchmarks.

Reasons for Recent Small Cap Underperformance in the U.S.

This cyclical performance has been studied extensively but the reasons for it are not widely agreed upon. One possibility is an industry effect. At this time in history, tech stocks are the market’s darlings. Industrials, energy, and materials are lagging. Many small caps are in these latter sectors, explaining the recent underperformance. When a return premium disappoints over a long period, investors tend to conduct postmortem analysis in an attempt to identify the cause. The candidate culprits include trends such as private equity activity, interest rate changes, and business cycles.

Another reason for small cap underperformance in the U.S. is the recent popularity of private equity. Rather than going public as small caps, growing companies now tend to remain private until they are mid-cap or larger. This phenomenon has caused small-cap indices to be overweighted in aging or unsuccessful companies.

In addition, merger and acquisition activity has caused small companies to be bought (and thus taken out of the public markets) by larger ones that face a low cost of capital and are flush with cash. Finally, private equity firms take many small companies private.

Sometimes the small companies that we own get purchased at premiums in the range of 25-30% – it’s great to be the target of the acquisition but this takes the most attractive companies out of the index or prevents them from entering.

Nevertheless, we believe there are many great opportunities in small caps. You just have to analyze the companies carefully.

Small Cap Performance in the U.S. and Internationally

These observations, however, seem limited to U.S. markets. The strength of the size premium outside the U.S. has been surprising. Over the last two decades, small caps in developed ex-U.S. and emerging markets have outpaced their large cap counterparts, even while small stocks have lagged in the United States (see Exhibit 2). The same general economic forces that purport to explain U.S. small-cap underperformance – private equity activity, low interest rates favoring large caps, and industry effects – also apply elsewhere, so it’s a puzzle why their impacts would show up only in U.S. markets.

The Case for Small Caps Now

Thus, small caps aren’t dead in the U.S. – they’re just misunderstood. (And, internationally, they were never dead.) Because of this cyclical performance, small caps are a diversifying asset. But diversifying assets need to perform well sometimes or it doesn’t help to hold them. Diversification consists of low correlation, but correlation isn’t everything; you also need to care about return. For example, a group of us could sit at a casino table in Las Vegas and earn a return that is negatively correlated with the stock market and each other – and all of us could lose money!

U.S. small-cap investors have had a rough ride for quite some time now. The last big move upward for these assets, relative to large caps in the U.S. market, was in the first six years of this century – a long time ago. (There were smaller moves upward in 2009-2011 and 2020-2021.)

So, what is the case for holding small-cap stocks now?

The answer lies in valuation, which is a forward-looking concept. One of the most reliable patterns in finance is that assets with low prices relative to their fundamentals – earnings, book value, cash flows, and so forth – have higher expected returns than assets with high prices relative to their fundamentals. As we illustrate in Exhibit 3, the relative valuation of small caps is historically attractive relative to large caps.

In today’s market, small caps are 40% cheaper than large caps and are at the cheapest level in more than 20 years.¹

The relative cheapness of U.S. small caps approaches the extremes reached in the internet bubble of 1999-2000. When the bubble burst, subsequent small-cap returns were among the highest in history, a 7.34% (see Exhibit 4) compound annual advantage over large caps from March 1999 to December 2006.

We may face a similar dynamic now, with the Magnificent Seven companies adding to 34% of the S&P 500, a record in modern times. These are stronger companies than the ones that dominated the market in 1999-2000, so we do not expect as dramatic a correction in relative performance, but the direction should be the same. Empirically, the forward relative performance of small caps has been better in periods following an increase in the concentration of large caps.

Moreover, while the Mag 7 have good prospects, there’s plenty of froth in this bull market. Palantir is selling at a P/E of nearly 600 (not a typo), DoorDash at 120, Spotify at 157. These are household names, not flash-in-the-pan startups. This kind of skewed pricing creates opportunities for managers who focus on less popular and smaller companies as well as those located outside the U.S. As a portfolio manager with a deliberate focus on smaller companies, we closely monitor valuation trends and believe they currently present compelling opportunities for investors.

Why History Is Interesting but Not Directly Relevant

Much has been made of the historical premium of small caps over large caps in the U.S., beginning with the famous studies of Rolf Banz (1981), Marc Reinganum (1981), and Ibbotson and Sinquefield (1982). Over the period studied, 1926-1981 (55 years), small caps outperformed large caps at a compound annual rate of over 3% per year, enough to generate a huge difference in ending wealth values over such a long period as shown in Exhibit 5.

However, in the 42 years since these papers were written – that is, since 1982 – small and large caps have taken turns at good performance, with a negative premium of over -1% on average over the period as shown in Exhibit 6. Investors taking this more recent experience and extrapolating it forever into the future would probably shun the asset class entirely. (Because of the cyclicality, they should not do this!)

This result casts doubt on there being a structural premium for “smallness.” To the extent there is a premium in expectation, it is probably because small companies are less closely followed and less widely held. Others support the idea that the premium is a compensation for the greater risk of small stocks.

As a result, the long and wide swings of the small vs. large performance cycle are much more valuable for thoughtful security analysis than the presence of a long-term premium. Right now, the swing in favor of low valuations (thus high expected returns) of small caps has gone almost as far as it ever has. Sooner or later, when the pendulum swings the other way – and this is impossible to time precisely – the relative outperformance of smaller issues is likely to be dramatic.

As globalization peaks and starts to recede, large multinational corporations have started to shift their supply chains back to domestic suppliers. Small-cap firms tend to generate a substantial proportion of their revenues in domestic markets. Thus, “reshoring” is a long-term theme that may benefit small-cap companies and provide investors with additional diversification benefits.

Many small caps are specialized manufacturers that stand to benefit from decoupling with China and some amount of additional economic reconfiguration due to tariffs. This principle applies to small caps in countries with low U.S. tariffs and countries with special advantages (Japan, Vietnam) in replacing China as a supplier.

Conclusion

In the last 10 years (2015-2025), large caps have outperformed small caps in 9 of those years, with 2016 being the only exception. See Exhibit 7. This year looks like it will extend the trend, with the horrible year-to-date (through July) returns shown in Exhibit 8.

Given this track record, some investors are ready to write small caps off entirely, even calling for their exclusion from portfolios. But declaring the death of U.S. small-cap equities is exactly the wrong thing to do (like getting out of equities after the 2007-2009 crash). History, valuation metrics, and macro conditions suggest a different story – one that points to an approaching comeback.

Making money in the capital markets is always about looking forward, not back. We study history to learn from it, not to rely on it repeating – and to understand the general relationships among asset classes, the economy, and investor behavior. But historical patterns only rhyme – they evolve differently each time.

One Size Does Not Fit All

Our research suggests that not all small cap stocks are likely to contribute to the future realization of the small stock premium. We need to do the analytical work, stock by stock. Not all of the companies are quality companies.

For example, small stocks with high relative prices and low profitability have lower expected returns compared to the broader small cap universe. Similarly, small stocks with high levels of investment, as measured by very high levels of asset growth, tend to underperform. This group may include firms with high year-over-year increases in debt issuance, equity issuance, or retained earnings.

Our research, and that of others, has shown that there are large differences in returns between stocks with high asset growth and stocks with low asset growth. (Perhaps counterintuitively, the stocks with low asset growth have had the higher returns because, beyond a certain point, much capital spending is unproductive.) This investment effect also helps to explain the poor performance of firms with high stock issuance, high debt issuance, and high merger and acquisition activity.²

Thus, current valuations of companies, along with growth prospects and other factors such as management quality, are the keys to success in picking stocks. Based on  these variables, we believe that the time for much better performance by small caps has arrived.

¹ The exhibit is constructed using a blend of price/book, price/sales, and 5-year average price/earnings ratios. Please see sources at the end of this document.

²See my podcast with Baruch Lev and Feng Gu on the Q Factor at https://quentcapital.com/theqfactor/the-reverse-learning-curve.

^*Please see sources at the end of this document.

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Sources

Source for Fama French

Fama/French US Large Cap Research Index Courtesy of Fama/French from CRSP and Compustat securities data. Includes NYSE securities (plus AMEX equivalents since July 1962 and NASDAQ equivalents since 1973) with larger market equity than the median NYSE firms; rebalanced annually in June. Fama/French and multifactor data provided by Fama/French.

Source for S&P 500

Ibbotson data courtesy of © Stocks, Bonds, Bills and Inflation Yearbook™, Ibbotson Associates, Chicago (annually updated works by Roger C. Ibbotson and Rex A. Sinquefield). Copyright 2025 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved

Sources for MSCI

Sources For Russell

Russell 2000 Index Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes.

Russell 1000 Index Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes.

Other Sources

Bloomberg

Quent Capital Research

Dimensional Returns

Disclosures

This material is for informational purposes only and does not constitute an offer to sell or solicitation of an offer to buy any security. Past performance is not indicative of future results. Different types of investments involve varying degrees of risk. There can be no assurance that the future performance of any specific investment strategy referenced in this letter will be profitable, or equal any corresponding indicated historical performance levels.

Gregg S. Fisher is the founder and portfolio manager at Quent Capital, a registered investment advisor that manages small-cap investment strategies. As such, Quent Capital may benefit from increased interest in small-cap investing. This research is intended for informational purposes only and should not be construed as investment advice.

The analyses and conclusions of Quent Capital contained in this letter include certain statements, assumptions, opinions, estimates, and projections that reflect assumptions by Quent Capital concerning anticipated results that are inherently subject to significant economic, competitive, and other uncertainties and contingencies and have been included solely for illustrative purposes. No representations express or implied, are made as to then accuracy or completeness of such statements, assumptions, estimates or projections or with respect to any other materials herein.

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Small Caps Aren't Dead — They're Misunderstood