Despite my generally happy disposition, near-perfect weather for a month now in Ontario, and stock markets at record highs, I am still not as happy as I could be. Why is that? Well, blame it on the

small-cap secto

r. As a fund manager focusing on small- and mid-capitalization stocks, I can’t help being slightly sad that these are still lagging the market. Looking at indexes this year, we see that the S&P 500 is up about 10 per cent year-to-date. Small caps, as defined by the Russell 2000 index, are up about two per cent; small-cap growth, about four per cent; small-cap value, about three per cent, according to Bloomberg LP data.

Smaller companies, historically, have done better than large companies. Why is this? Well, typically two reasons are cited. 1. Faster growth: it is simply easier for smaller companies to grow. One large contract might have a giant influence on fundamentals. Whereas if a company is at $4 trillion market capitalization, even a $500 million contract is hardly noticeable. 2. Mispricing: Because small companies are not as well-known, and are often perceived as risky, they can (when times are good) outperform. Mispriced growth can be a powerful influence on investment performance. If we look at current price/earnings ratios, the S&P 500 is about 25.2 times earnings. Small caps, if we only include profitable companies in the Russell 2000 index, are at about 18 times earnings. So, many small companies, even with faster growth, are now cheaper than large-cap companies.

What will it take for small- and mid-cap companies to finally start moving? Let’s look at five possible catalysts.

Lower interest rates

Likelihood: High. Small caps depend more on borrowing and typically pay higher rates. When

interest rates fall

(as expected in the U.S. this year), small companies’ funding costs drop, supporting higher future earnings and stock price appreciation. Historically, small caps have only begun sustained outperformance several cuts into the rate-lowering cycle, so extended monetary easing could act as a catalyst for movement. There is also a big investor sentiment shift when rates start to move lower, and investors are more willing to take on risk with investments in smaller companies.

Moderating inflation

Likelihood: High (based on this week’s U.S. CPI numbers).

High inflation

and rising wages have been major headwinds, hitting small caps harder because they lack the pricing power of large companies. Continued moderation in inflation would ease cost pressures, helping small caps grow earnings and potentially attracting investors back to the segment.

Improved investor sentiment

Likelihood: Maybe. As noted above, a shift in sentiment can be a powerful influence. Over the past few years, investor attention has been dominated by large-cap tech stocks and the AI boom. As enthusiasm for large caps cools or broadens to new sectors, small caps could benefit from increased investment flows, especially in financials, industrials and healthcare, which have sizable representation in small-cap indexes. Also, as noted, with large caps facing high valuations, small caps now trade at significant discounts, making them more attractive for value-oriented investors. But we would use caution here. Since the megacaps have been leading the market, we need a shift in investor attitude to get small caps to run. If the megacaps experience a sharp correction for fundamental issues (lower growth or company issues) then the whole market might become weaker, and in that case small caps would not likely outperform.

Domestic policy tailwinds

Likelihood: High (offset by

tariff issues

). The recent U.S. political shift includes promises of deregulatory policies, tax cuts, fiscal stimulus, and support for reshoring business operations to America. These policies are expected to disproportionately benefit smaller companies more exposed to the domestic economy and less able to absorb compliance costs. Support for U.S. manufacturing and infrastructure, along with a focus on defence and technology, could channel new investment into small-cap sectors. While all that is positive for the small-cap sector it is largely offset by massive uncertainty surrounding tariffs, which may void much of the benefits.

M&A activity and corporate actions

Likelihood: Very high. With stock markets at records, corporate earnings high and interest rates heading lower, overall investor confidence improves. As uncertainty fades and corporate confidence rises, more

mergers and acquisitions

or IPO activity could unlock value and provide direct market catalysts for individual small caps or the segment broadly. We have already seen lots of merger activity in the small-cap space this year, and if this continues it could provide a good backdrop for improved performance.

  • 5 things in markets that will make you do a double-take
  • 5 reasons to be worried about the market today

In summary, getting small-cap stocks moving again will require a combination of rate cuts, sustained moderation in inflation, improved investor sentiment, supportive fiscal and domestic policies, increased M&A activity and a renewed appreciation of historically low valuations. These factors should start to converge, potentially positioning small caps for outperformance after extended lagging years. Investors should focus on high-quality companies with strong growth prospects within the small-cap universe for the best risk-adjusted returns.

Peter Hodson, CFA, is founder of 5i Research Inc., an independent investment research network helping do-it-yourself investors reach their investment goals. He is also portfolio manager for the i2i Long/Short U.S. Equity Fund. (5i Research staff do not own Canadian stocks. i2i Long/Short Fund may own non-Canadian stocks mentioned.)

If you like this story,
sign up for
the FP Investor Newsletter.