Small-Caps Take “The Pause That Refreshes” But Stay in the Lead

The summer months saw small-cap returns cool while mega-caps and other large, mostly AI-centric names rebounded. For the quarter, both the Russell 2000 and Russell Microcap Indexes finished in the red, with each index slipping -7.2%. The Russell 1000 Index, on the other hand, was up 1.8% while the mega-cap Russell Top 50 Index rose 4.1%.

Large- and Mega-Cap Stocks Beat Small- and Micro-Cap
3Q26 Russell Index Performance

Past performance is no guarantee of future results.

Year-to-date through the end of September, however, small- and micro-cap stocks remained ahead of their larger counterparts. The Russell 2000 advanced 13.7%, and the Russell Microcap increased 18.3% compared to respective gains of 12.3% and 6.2% for the Russell 1000 and Russell Top 50 for the year-to-date period ended 9/30/26.

Equally important from our perspective as small-cap specialists, cycle returns also saw the small- and micro-cap indexes well out in front: from the trough on 4/8/25, the Russell 2000 rose 61.9%, the Russell Microcap gained 93.4%, the Russell 1000 was up 55.5%, and the Russell Top 50 rose 55.1%.

Small- and Micro-Cap Remained Impressive off the 2025 Market Low
Russell Index Performance, 4/8/25-9/30/26

Past performance is no guarantee of future results.

We detail the fundamentals-based case for small- and micro-cap stocks below but suffice it to say that the respective intra-quarter corrections for small- and micro-caps, -8.6% and -7.5%, did nothing to curb our enthusiasm for extended small-cap leadership.

Mega-Cap Tech Names Dominated in 3Q26

In this mixed quarter for equity performance, the rebound for mega-cap stocks was driven by robust results for Apple, Meta, and Microsoft, along with several large-cap software and semiconductor names—Advanced Micro Devices, Micron Technology, and Nvidia most prominently.

The dynamics in tech were notable in the quarter. July saw a rotation away from AI infrastructure stocks (including a number of small-caps and semiconductor stocks of all sizes) and into sector laggards, setting the stage for August’s rebound in software stocks. The industry was thought to be in danger of possibly imminent seismic change—if not obsolescence—due to AI encroaching on many software specialties. Once that notion was recognized as an extreme overreaction, software bounced back.

September then saw the release of OpenAI’s GPT-6, which helped reignite demand for chip makers and push the Nasadq to a new all-time high on the twenty-first. Meanwhile, the torrid pace of the AI infrastructure buildout showed no signs of slowing down, with estimates for 2026 in the area of $700-$775 billion for hyperscaler CapEx alone.

An unanswered question is why small-cap semiconductor and other names involved in the AI buildout have not yet attracted a similar level of renewed investment. In light of the fundamental strengths that many smaller companies in this space possess, we suspect it is just a matter of time.

Foreign Affairs

Outside the U.S., where the AI trade is less of a factor, results decoupled from the pattern of their stateside peers in 3Q26 (as was the case in 2Q26). In the third quarter, small-caps outperformed, with the MSCI ACWI ex-USA Small Cap Index advancing 2.1% in 3Q26 while the MSCI ACWI ex-USA Large Cap Index was essentially flat, gaining 0.1%.

For the year-to-date period ended 9/30/26, the MSCI ACWI ex-USA Small Cap Index gained 11.4%, and the MSCI ACWI ex-USA Large Cap Index was up 14.5%.

Inside Small-Cap: Value Leads in 3Q26 and From the Cycle Low

Unsurprisingly given its long record of tending to lose less during downdrafts—even short and minor ones—small-cap value fared better than its growth sibling in 3Q26, with the Russell 2000 Value Index down -4.9% and the Russell 2000 Growth Index losing -9.4%. Somewhat counterintuitively, however, small-cap value also led the year-to-date period ended 9/30/26, up 17.0% versus 10.7%, as well as in the current, very bullish cycle. From 4/8/25 through 9/30/26, the Russell 2000 Value gained 63.4% versus 60.5% for the Russell 2000 Growth.

The Small-Cap Sector Story: Industrials and Tech Stumble

Ten of the 11 sectors in the Russell 2000 finished 3Q26 in the red, with Industrials, Information Technology, Financials, and Consumer Discretionary detracting the most by far. Energy was the only positive contributor, boosted by higher energy prices that helped the oil, gas & consumable fuels industry. Despite the sector’s negative results, Health Care saw robust returns from health care equipment & supplies and life sciences tools & services.

Industries making positive third-quarter contributions were in short supply, while semiconductors & semiconductor equipment, biotechnology, machinery, banks, and construction & engineering, headed up a lengthy list of industry detractors.

The picture was far sunnier for the year-to-date period ended 9/30/26, in which Information Technology, Industrials, and Health Care led a list of 9 positive contributors. Consumer Discretionary and Utilities were the detractors—and each detracted quite modestly. The top-contributing industries were semiconductors & semiconductor equipment, electrical equipment, and biotechnology while specialty retail, real estate management & development, and passenger airlines were the top detractors.

Resilience Remains the Theme

Even accounting for the 3Q26 pullback for smaller companies, the resilience of both the market and the U.S. economy has been rather remarkable. Among the current headwinds are a supply shock with oil, stubborn inflation, higher interest rates, a sluggish housing market, ongoing geopolitical conflicts, and ever sharpening political divisions (with elections looming).

Yet through all these formidable challenges, the economy keeps chugging along with low unemployment, vibrant industrial activity, and continued spending by consumers (arguably the unsung heroes of the U.S. economy). To be sure, today’s conventional wisdom insisting on consumer weakness is somewhat unfounded and is not universally true. Retail sales, for example, have been increasing at a fairly steady rate since following a post-holiday low in February. In addition, credit spreads remain reasonable, especially in the investment grade and high-yield areas. For small-caps, the backdrop is still supportive, at least for companies with strong balance sheets.

Why Higher Rates ≠ Lower Small-Cap Returns

From our small-cap centric perspective, the case for small-cap leadership looks essentially unchanged. One could even argue that it has improved a bit in the aftermath of the down quarter. Of course, some observers began sounding the death knell for small-cap leadership as soon as the Fed raised rates and hinted that two more increases were likely if inflation does not subside.

When we looked at previous Fed tightening cycles, however, we found little evidence that higher interest rates translated into poor small-cap performance. In fact, our research revealed that earnings were a far more accurate gauge of small-cap performance on both an absolute basis and relative to large-cap stocks. Over time, share prices and earnings consistently converged. Interest rates have occasionally influenced valuations and investor sentiment, but mostly over short-term periods. Long-term returns ultimately followed the path of earnings. And earnings growth continues to accelerate for both small- and large-cap companies.

Higher rates are going to have a more pronounced effect on stocks with the highest multiples. These most expensive areas (which are also where most of the concentration is) will likely feel the negative effects of higher rates more than small-caps with earnings in terms of how they impact multiples.

Why Small-Cap Fundamentals Matter

Indeed, with rates on the rise, conservatively capitalized balance sheets once again have economic value. Cash-rich small-cap companies are now getting a return on that cash, which they hadn’t for close to 20 years (going back to the Great Financial Crisis of 2008-09). Strong balance sheets are a positive attribute for many reasons. One that is especially relevant today is that they give companies the opportunity to make acquisitions, invest in their business, and/or further differentiate themselves against companies that are worried about the need to refinance at higher rates.

We also looked at additional revealing metrics and found that small-cap weakness in 3Q26 was not accompanied by any deterioration in aggregate fundamentals. In breaking down the Russell 2000’s 3Q26 results, sales per share rose 2.9%, free cash flow per share rose 11.2%, and EPS (earnings per share) rose 19.5% (though none of these positive metrics was enough to five the small-cap index a positive return for the quarter). By contrast, free cash flow per share increased only 6.6% for the Russell 1000, and EPS increased 10.2%.

Bolstering the case for ongoing small-cap leadership to continue is the fact that consensus estimates are pointing to faster earnings growth ahead (as they have for most of the last year).

Small-Cap’s Estimated Earnings Growth Is Expected to Be Higher Than Large-Cap’s in 2026 and 2027

Earnings per share (EPS) is calculated as a company’s profit divided by the outstanding shares of its common stock. The EPS Growth Estimates are the pre-calculated mean one-year EPS growth rate estimates by brokerage analysts. Estimates are the average of those provided by analysts working for brokerage firms who provide research coverage on each individual security as reported by FactSet. All non-equity securities, investment companies, and companies without brokerage analyst coverage are excluded. Data was run on October 1, 2026. Source: FactSet.

We then looked at valuations for small-cap as a whole as well as at the level of style to see if value or growth were significantly cheaper or more expensive than their long-term EV/EBIT averages (EV/EBIT, or enterprise value over earnings before interest & taxes is our preferred index valuation metric, which we also use when screening companies). We found that small- and micro-cap value and micro-cap core are still the cheapest segments of the U.S. equity market and that these segments are either just below or slightly above their 25-year average valuation; while all three value segments have somewhat similar 25-year average valuations, their current valuations are vastly different; and that overall large-cap valuations still have a long way to fall to reach their 25-year average valuations.

The Russell Microcap Value, Russell Microcap, Russell 2000, and Russell 2000 Value Remain Near Their Historical Average
Current and 25-Year Average Median EV/EBIT (ex. Negative EBIT) Levels for Russell Indexes as of 9/30/26

We also want to make a point about the duration of leadership cycles. Using the CRSP (the Center for Research in Security Prices) 6-10 as our small-cap proxy and the CRSP 1-5 for large-cap, we went back nearly a century to get a sense of how often and how long each asset class held leadership. (The Russell indexes only go back to the end of 1978.) Our research found eight full cycles prior to the current period, beginning at the end of 1931. Each asset class enjoyed four leadership periods. As the chart below shows, small-cap had two of the three longest cycles; large-cap had the longest and the shortest periods. Most relevant to us is the fact that regardless of which asset class was on top, leadership was durable—the shortest was a large-cap span of 5 years, from the late 1960s into the early ‘70s. The three longest periods lasted at least 14 and as long as 16 years.

Historically Small-Cap Cycles Have Averaged More Than a Decade
Small-Cap and Large-Cap Market Cycles: Average Monthly Relative Performance for CRSP 6-10/CRSP 1-5 from 12/31/31 through 8/31/26 (%)

Past performance is no guarantee of future results.

Stay Active!

Our investment playbook has not changed. We remain focused on fundamentals and seek to use downdrafts the same way that we use periods of volatility—by acting opportunistically to invest in high-quality small-cap businesses with long runways for growth. And while volatility was modest in 3Q26, small-caps returns fell pretty consistently in July and September (with a brief respite from the downward trend in August), allowing our investment teams to build select high-conviction positions and investigate new ideas.

Most of our teams continue to enjoy the sweet spot between holdings that are doing well while still finding what they think are excellent long-term opportunities in the wide and diverse universe of small- and micro-cap stocks. Many companies that fit our different investment criteria are trading at what we think are attractive multiples. Most are discrete opportunities, but we are finding them in nearly every sector and industry. We also think it’s important to remember that, for all the talk about the 40% of money-losing companies in the Russell 2000, there are currently 1,130 companies with earnings in the Russell 2000 versus only 900 in the Russell 1000.

Finally, we think that periods like the present reinforce the value of active management. Small-cap stocks currently sit between two crowded institutional allocations: Mega-cap stocks and illiquid private markets, which are both at valuation extremes. So small-caps really can solve a lot of problems in equity allocations. The asset class’s enticing combination of relatively more attractive valuations and ongoing earnings strength solidifies our conviction that the current environment offers compelling opportunities for active, fundamentals-driven investors with a long-term horizon.

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