Despite mid-to-late November market volatility, we continue to view this as an especially interesting time to be an investor in the equity markets. The industrial revolution of artificial intelligence (AI) has begun and adoption by companies across virtually all industries is fast and furious.
The potential benefits of efficiency and innovation are incalculable. The societal impact is still unknown, but subject matter for another writing.
When it comes to equity investing, we should try and take the longer view. Of course, investors have had a banner year so far, with the S&P 500 Index of large companies up 17.2% and the Russell 2000 Growth index of smaller companies up a respectable 15.1% as of 31 October.
We continue to believe that some of the best future opportunities can be found in smaller companies – often defined as micro-caps, small-caps and mid-caps – with market capitalisations generally between $500m and $15bn.
Certainly, not speculative penny stocks, but also not the mega-caps with the likes of the ‘Magnificent 7’ club. Of course, as these enormous companies thrive and invest their billions in future growth, there is certainly a trickle-down benefit to smaller companies.
At less than 4%, small-caps represent a historic low share of the equity market. It is the lowest since the 1930s and is compared with historic levels typically between 7% and 13%. Several indicators highlight why US small caps may be poised for a recovery.
Market-cap dislocations
Following periods of excessive large-cap dominance, US small-caps have historically delivered stronger relative returns over subsequent five and 10-year periods.
When large-cap valuations run far ahead of the rest of the market, the gap has tended to narrow in the years that follow, often in favour of smaller companies. The question now is whether this cycle and historical pattern will follow the same script.
Investor abandonment of small-caps
Beginning in 2006, investors have been reducing their exposure to US small companies, as measured by investment in US exchange-traded funds (ETFs).
Ultimately, price recognition is driven by positive demand, which has diminished over the past 20 years from 11% to 6%.
Multiple valuation of small-caps are at historic lows
Looking at the most relevant valuation metrics – price-to-book (P/B) and price-to-sales (P/S) –small-caps are at significant historical lows relative to large-caps, with the Russell 2000 trading at 0.4x P/B and 0.45x P/S relative to the S&P500.
Relative to their larger-cap brethren, small-caps offer relative value. As we head into year-end, the market has seen increased volatility as investors fret over near-term interest rate action by the Federal Reserve, Mag 7 equity prices, increases in borrowing to fund the rapid expansion of AI-related infrastructure and a lack of economic transparency due to the delay of released government data.
We believe none of these have any meaningful impact on the long-term economic outlook or where equity prices will be even a year from now but this is consistent with how market participants behave on a short-term basis.
The longer-term economic outlook continues to benefit from constructive tailwinds
Expectations for lower interest rates into 2026, with a new dovish Fed chair starting in May, support growth, while capital expenditures among leading AI companies – with hundreds of billions in balance sheet capital and loans – provide additional momentum.
A beneficial tax and regulatory regime (president Donald Trump’s Big Beautiful Bill), continued resilience in consumer spending with low unemployment and the actual innovation benefits from AI (this is not the dot.com bubble) all point to a supportive environment for the economy moving forward.
Rob Gordon is investment director at VAM Funds. The views expressed above should not be taken as investment advice.