4 reasons forecasters are bullish on the market's smallest stocks after years of underperformance

Business Insider

02-07-2025

Stock forecasters can't stop talking about the market's smallest and least impressive stocks.
They're referring to the small-cap sector, an area of the stock market that strategists have been bullish on, despite underperforming the overall market in recent years.
The Russell 2000, which slipped into a bear market over the first half of the year, has recouped most of its losses in recent months. But the index of small-cap US firms is still down about 1% year-to-date, lagging the S&P 500 's 5% gain.
On a five-year horizon, the Russell 2000 has yielded a 53% return — underwhelming compared to the S&P 500's 98% climb.
But there are a few reasons some forecasters remain bullish on the sector. Here's what strategists are saying.
1. A possible IPO boom on the horizon
There's reason to believe that more small, private companies are gearing up to go public in the near term, according to analysts at Janus Henderson.
Small private firms have typically relied on private equity investors to get fresh capital, but many private loans are structured over a 5- to 7-year time horizon, analysts said, and companies will likely be looking for new sources of money once the debt matures.
Interest rates are also higher than they were in the past decade, which could make it more challenging to attract private investors, they added.
"That's why going public could become a more attractive path for companies needing refinancing or private equity sponsors looking for an exit," analysts said, pointing to the surge in IPOs over the first half of 2025 compared to the prior year. "A reopening IPO market typically benefits the entire small-cap asset class as quality companies tend to go public first and generate positive momentum across the space."
Rebounding from a bear market
Small-cap stocks have historically performed well after bear markets, according to an analysis from Royce Investment Partners.
The Russell 2000 fell into a bear market earlier this year, falling 21% from January to April 8, and historically, stocks in the index have seen healthy growth following a trough.
In 2020, the Russell 2000 plunged more than 30% peak-to-trough amid the broader coronavirus-fueled sell-off, but value and growth stocks in the index more than doubled in value in the year following the event, according to Francis Gannon, the co-chief investment officer at Royce.
Over the last 20 years, small-caps gained an average 60% in the year following a bear market, Gannon added in a note.
Valuations in the sector also remain attractive.
"We see the small-cap market as fundamentally healthy. The disconnect between large caps and small caps reflects market sentiment rather than underlying business performance," analysts at Janus Henderson said.
Strong investment themes
According to Jill Hall, the head of US small and mid-cap strategy at Bank of America, small-cap stocks should also benefit from a handful of bullish themes unfolding in the broader economy.
Here are some of the tailwinds Hall sees:
Reshoring. The economy moving more of its manufacturing activity back to the US could be a boon for small public companies. In a note last year, Morgan Stanley estimated that restoring could unlock as much as $10 trillion in value for the US economy over the next decade.
Capital expenditures. The US is in the midst of a big capex cycle, which could also benefit small firms, Hall suggested. US private fixed investment clocked in around $4.2 trillion in the first quarter of 2024, according to data from the Bureau of Economic Analysis
De-globalization. The US decreasing its reliance on supply chains abroad could also support small domestic firms.
"Overall, I do think that over the long-term, there is still greater potential for outperformance of small-caps, given where valuations are, and given some of the multi-year themes," Hall said, speaking to CNBC this week.
The America-first economy
The Trump administration's push for an America-first economy should also benefit small public firms, according to Peter Kraus, the CEO of the asset manager Aperture Investors.
Kraus pointed to the GOP tax and spending bill, which includes proposals like extending Trump's 2017 tax cuts and bigger tax breaks for some businesses and workers.
"Congress is going to focus on the domestic economy, and I do think domestically oriented companies, principally mid-cap and small-cap companies, are going to benefit. And they've been the laggards in the last five years," Kraus said, speaking to CNBC on Tuesday.