CONTRIBUTORS
Francis Gannon
Co-Chief Investment Officer, Managing Director, Royce Investment Partners
Lost among the daily headlines centered on economic uncertainty, geopolitical worries, and new highs in the large-cap market, the recent outperformance of small-caps has gone mostly unnoticed. In fact, through 8/22/25, the Russell 2000 Index was outperforming the Russell 1000 Index for the third quarter to date and, more importantly in our view, since the tariff tirade lows of April 8th. The Russell 2000 was up 8.8% for the quarter-to-date versus 4.4% for the Russell 1000 (and 5.1% for the mega-cap Russell Top 50). From the 2025 market low on 4/8/25, the Russell 2000 advanced 34.8% versus 30.7% for the Russell 1000. Micro-caps did even better over the same period, with the Russell Microcap Index climbing 46.6%.
The question remains whether or not this is another head fake for small-cap’s relative performance or the beginning of a sustainable trend. From our perspective, investors appear to (finally!) be realizing that the equity market is both broad and deep. It offers alternatives (we sometimes describe small-caps as “the original alternative asset class”) beyond currently expensive, concentrated large- and mega-cap names.
Equally encouraging in the context of the current rally is that the Russell 2000 remained much less expensive than the Russell 1000 at the end of July. Based on our preferred index valuation metric, EV/EBIT, or enterprise value over earnings before interest and taxes, small-caps remained close to a 25-year low relative to large-cap stocks, a status that recent short-term outperformance has done only a small bit to change. Well-rehearsed concerns that the US market is expensive does not apply to many companies in our market cap ranges—which is similar to the buildup and aftermath of the tech bubble of 2000-01.
We think that small-caps’ far more attractive valuations become even more compelling when combined with the promising earnings outlook vis-à-vis large-caps. With many small-cap companies just beginning to emerge from a two-year earnings recession, earnings growth should help boost performance for an asset class that’s lagged large-cap for several years and still faces low expectations. Potentially enhancing this positive picture is the recently signed federal legislation that allows businesses to deduct up to the entire cost of eligible assets in the year they are placed in service. This accelerates deductions, reducing taxable income and augmenting cash flow in the year of purchase. To put it more simply, small-caps have considerable potential for multiple expansion through the end of 2025 and beyond. (And while on the topic of earnings, we note that the recent strong run for the Russell 2000 looks even more impressive given that more than 14% of companies in the index that reported disappointing earnings so far in 3Q25 have declined -10% or more.)
Since most of our domestic small-cap strategies focus on companies with earnings, we think it’s also worth mentioning that previous periods during which small-caps had low expectations and relatively underwhelming returns typically proved to have been opportune times to increase allocations.
Finally, the dynamic of businesses benefiting from the ongoing AI revolution has shown encouraging signs of shifting from the companies that own the models to the companies that benefit from the models—that is, small-caps.
Investors therefore appear to be seeking alternatives to the upper reaches of market capitalization in their asset allocations, seeing in small-caps both domestic and international highly promising long-term opportunities.
It is a trend we expect to continue!
Stay tuned…
Definitions
The Russell 1000 Index is an unmanaged, capitalization-weighted index of domestic large-cap stocks. It measures the performance of the 1,000 largest publicly traded US companies in the Russell 3000 Index.
The Russell 2000 Index is an index of domestic small-cap stocks that measures the performance of the 2,000 smallest publicly traded US companies in the Russell 3000 Index.
The Russell 2000 Value and Growth indexes consist of the respective value and growth stocks within the Russell 2000 as determined by Russell Investments.
The Russell Top 200 Index measures the performance of the 200 largest companies in the Russell 1000 Index.
The Russell Microcap Index measures the performance of the microcap segment of the US equity market.
The Russell Top 50 Mega Cap Index is a market-capitalization-weighted index of the 50 largest stocks in the broad-based Russell 3000 universe of US-based equities.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
Equity securities are subject to price fluctuation and possible loss of principal.
Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
Small- and mid-cap stocks involve greater risks and volatility than large-cap stocks.
US Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the US government. The US government guarantees the principal and interest payments on US Treasuries when the securities are held to maturity. Unlike US Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the US government. Even when the US government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.
Investments in fast-growing industries like the technology sector (which historically has been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and development and changes in government regulation of companies emphasizing scientific or technological advancement or regulatory approval for new drugs and medical instruments.
Any companies and/or case studies referenced herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio. Past performance does not guarantee future results.
Any data and figures quoted in this article sourced from Russell Investments, FactSet, Bloomberg and Reuters.
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