The investment opportunity in U.S. small-caps and benefits of employing an active approach

February 2025

From the Office of the CIO
Shaun O’Malley CFA, SVP
Head of Equities, Citizens Private Wealth

U.S. small-capitalization equities (small caps) can benefit when market sentiment shifts from uncertainty to opportunity, offering outsized growth potential as investor confidence returns. After years of underperformance relative to their large-cap peers, many small-cap companies have been overlooked and trade at attractive valuations. We see an opportunity for investors to capitalize on favorable U.S. economic dynamics by implementing a small-cap allocation and a compelling case for active management amidst an evolving macro environment.

The case for U.S. small caps

U.S. economic strength: The performance potential of U.S. small caps is closely tied to U.S. economic growth and domestic demand. As the U.S. economy demonstrates resilience supported by a vibrant labor market, strong consumer consumption and steady growth, we believe small caps are well-positioned to benefit. As highlighted in our Citizens Private Wealth 2025 Investment Outlook, we prefer U.S. economic growth dynamics over those abroad and are optimistic that U.S. economic leadership will continue under the Trump administration. The International Monetary Fund’s (IMF) latest economic forecasts underscores this outlook (see Figure 1), projecting that the U.S. will remain a leader in global economic growth with unmatched resilience among developed nations.

Stronger U.S. dollar and trade policies: A stronger U.S. dollar generally benefits small-cap stocks due to their lower international revenue exposure. Small caps rely more on domestic sales that are less impacted by foreign exchange rates and have significantly higher exposure to U.S. revenue streams than U.S. large-cap and international equities. The constituents of the Small Cap S&P 600 Index generate 79.8% of their revenue in the United States versus just 58.7% for the S&P 500 Index. In addition, trade policies and tariffs aimed at bolstering domestic industries favor smaller companies with localized supply chains, enabling small caps to capture increased market share (see Figure 2).

Increasing M&A activity: Small-cap stocks are attractive acquisition targets, particularly as large-cap companies with strong balance sheets seek growth through strategic acquisitions. Improving sentiment around deal flow, supported by expectations of a more favorable regulatory environment, further strengthens this trend. According to the Citizens 2025 M&A Outlook, 54% of middle-market leaders and private equity decision-makers view the current M&A environment as strong, citing economic growth, fading inflation worries, and stabilizing valuations as key drivers (see Figure 3).

Sector composition: Small-cap indices have greater exposure to cyclical sectors such as financials, industrials, and consumer discretionary, which benefit from domestic consumer spending, as well as infrastructure projects and reshoring initiatives. In addition, they have less exposure to the lofty valuation multiples of the information technology sector and the concentration risks present in large cap indices. The small-cap sector composition provides balanced and prudent diversification to out-of-favor segments (see Figure 4).

Concentration risk: The U.S. large-cap equity market is heavily concentrated in a few dominant tech stocks, amplifying risks beyond elevated valuations. A shift in investor sentiment away from the Magnificent Seven — which make up more than 30% of the S&P 500 — and the broader mega-cap universe could lead to increased inflows into small caps as investors seek diversification and new growth opportunities. Additionally, the less concentrated small-cap investment landscape provides active managers with a broader opportunity set to identify differentiated growth prospects and navigate potential market shifts. Valuation disparity and earnings optimism: Small-cap stocks are currently trading at attractive valuations with a forward price-to-earnings ratio of 15.1x for the S&P 600, which represents a significant discount to 21.2x for their S&P 500 large-cap peers (see Figure 5).

The valuation gap reflects investors’ preference for financially resilient companies with high profitability, strong cash flow, and pristine balance sheets, alongside the excitement surrounding AI-driven growth seen in large-cap stocks. The valuation disparity has remained relatively consistent over the past year as the strong demand for the Magnificent Seven has continued to elevate large-cap valuations. Investors seeking to broaden market exposure may look toward the overlooked small-cap segment, which benefits from a combination of lower valuation and improving growth expectations. The Russell 2000, a commonly used U.S. small-cap index, is projected to grow earnings by 44% in 2025,1 meaningfully higher than the 14% growth rate expected for large caps.

The active management advantage

We believe the value proposition of U.S. small-cap equities remains underappreciated by the markets. As the macroeconomic landscape continues to evolve and investors absorb the impact of the policy changes proposed by the new administration, allocating to small caps through an actively managed strategy represents the most effective way to invest in this segment. While small caps offer attractive valuations, differentiated sector exposure and a strong correlation to U.S. economic growth, they also present unique challenges. This is where skilled active managers can add value — by navigating the market inefficiencies, focusing on higher-quality companies and avoiding the broader risks compared to small-cap index investing. The additional factors outlined below support the case for active management and highlight why it is best-suited to capitalize on opportunities within the small cap universe.

Market inefficiency: The small-cap market is inherently less efficient than the large-cap market, meaning prices often fail to fully reflect all available information. The primary drivers are limited Wall Street analyst coverage, lower institutional ownership and reduced liquidity. Several dynamics present opportunities for skilled active managers to identify and capitalize on undervalued stocks.

Higher quality focus: The Russell 2000 includes many low-quality stocks, ranging from unprofitable companies to heavily indebted “zombie” firms. The percentage of Russell 2000 companies producing negative earnings has risen from just 14% in 1994 to 43% as of Q4 2024.2 Active managers can avoid these underperforming companies and concentrate on higher-quality names that reduce downside risk while enhancing returns.

Underfollowed by Wall Street: Many small-cap stocks have minimal or no analyst coverage, making them less visible to the broader market. This creates opportunities for active managers to identify hidden gems overlooked by passive investors.

Increased potential of outperformance: The S&P Indices Versus Active Scorecard (see Figure 6) corroborates our view that skilled small-cap managers can add value relative to the index. In fact, active small-cap managers have historically outperformed their respective index relative to managers in the large-cap space.

Risks to our outlook

The greatest risk to a U.S. small-cap allocation is domestic economic weakness and the possibility of a recession. While our base case assumes resilient growth and strong employment in the U.S., we are closely monitoring inflation trends and potential Federal Reserve policy shifts that could disrupt economic growth expectations for the year.

Conclusion

Small-cap stocks may currently be out of favor, but we believe they are well-positioned to benefit from domestic growth trends and U.S. economic resilience. An actively managed approach provides an opportunistic yet defensive approach, enabling investors to capitalize on opportunities while navigating periods of change and uncertainty.

About the author

Shaun O’Malley serves as Head of Equities and is a Portfolio Manager for Citizens Private Wealth, leading the firm’s internal equity strategies. In his role, he conducts in-depth fundamental research, performs industry and sector analysis and selects individual stocks, while overseeing a team of equity research analysts. Shaun is also a voting member of the Investment Policy Committee, contributing macroeconomic research and providing tactical asset allocation recommendations. Before joining Citizens in 2012, Shaun was an investment specialist at Bank of America Merrill Lynch and worked with high-net-worth clients at Boston Private Bank. Shaun earned a B.S. from Bryant University and an MBA from the Carroll School of Management at Boston College. He is a CFA charterholder and member of the CFA Society of Boston.