Small-cap stocks – Dusted into irrelevance, or a logical opportunity?

The S&P 500® Index has been on an all-encompassing tear for the past decade, with performance being driven by just a handful of shiny mega-cap tech stocks. This large-cap technology focus has left many asset classes behind, unloved and undervalued.

International stocks began this year in an unpopular, undervalued state but recovered dramatically. International small-cap stocks gained about 40% year-to-date in 2025, a generally unexpected reversal of fortune that benefited Frontier strategies.

Trends don’t last forever, and leadership changes are constant in capital markets. So, what of U.S. small-cap stocks then? Will 2026 be the year of small-cap stocks? Are they unloved and undervalued, poised to recover, or have they been dusted into irrelevance?

Misunderstood

This year marks the greatest 10-year outperformance of large-cap stocks relative to small-cap stocks on record, according to S&P indexes. This has caused many investors to ignore U.S. small-cap stocks and some to even present a narrative that small-cap stocks are irrelevant in the modern landscape. Arguments against small-cap stock investing? The businesses are too small and irrelevant in the face of the likes of today’s technology leaders, there are not enough relevant small cap stocks to choose from, and small cap stock indexes are loaded with “zombie” businesses are three common narratives that are presented as the case against small-cap stocks.

1. Not that small: It’s all a matter of perspective.
   Compared to the S&P 500, yes, the S&P 600 Index is made up of smaller capitalization companies, but it’s all a matter of perspective. First off, the S&P 600 Index is comprised of businesses with market capitalizations between about $1 and $8 billion. Most of these companies have been in business for decades, have established presences in their markets, and can employ thousands of employees.
2. Not enough companies to choose from
   One of the more interesting arguments against owning small-cap stocks is based on the idea that, since the rise of private equity, there are less IPOs, and thus a reduced amount of relevant small-cap stocks to choose from. Well, there are 600 stocks in the S&P 600 Index and about 2000 stocks in the Russell 2000 Index. Last time I checked, both of these indices had more stocks to choose from than in the S&P 500 Index. Investors haven’t balked at how few stocks there are to choose from in the large-cap space.
3. Unprofitable businesses
   The biggest myth about small-cap investing is that it is synonymous with unstable, unestablished, risky operations. More broad small-cap indexes, like the Russell 2000, include every company that fits its size criteria, regardless of whether it makes a profit. This means that some small-cap indexes can hold what investors deem to be “zombie companies” – businesses that can barely cover their interest payments, let alone turn a consistent profit. For example, as of late 2025 about 40% of the stocks that make up the Russell 2000 Index were not profitable.
   Source: Yahoo Finance. “Fortune: 40% of Russell 2000 companies are unprofitable, but their stock outperforms–and ‘the bubble could continue,’ one analyst says.” October 21, 2025.

The quality small cap alternative

Experienced investors know there’s a more concise benchmark: the S&P 600 Index. The S&P 600 is built on a simple yet powerful filter: companies must demonstrate a track record of positive earnings over the most recent four consecutive quarters to be included.

This profitability screen weeds out the zombies, creating a higher-quality index that has historically outperformed its broader cousin, the Russell 2000, over the long term. The S&P 600 Index has outperformed the Russell 2000 Index across 80% of three-year time periods. While the S&P 500 has been all about the AI hype, and the Russell 2000 has been the popular small-cap index, the S&P 600 has been quietly compiling a roster of fundamentally sound, growing businesses that actually make money.

All of these are interesting narratives, but these stories are qualitative and subjective. When investing, though, we care most about returns in the future, which often have little to do with the narratives of the past. So, can they perform in the future?

Left behind, but ready to roar back?

For five straight years, large caps have crushed small caps, creating the largest valuation gap since the peak of the dot-com bubble in the late 1990s. But I wouldn’t count them out just yet. History points to important concepts, market cycles, and leadership changes.

Rolling Five-Year outperformance of small-cap stocks vs. large-cap stocks

S&P 600 Index – S&P 500 Index

Throughout history, there has been an oscillation of performance leadership between large- cap and small-cap stocks. History also tells us that when technology stocks are the market leaders, it is hard for small-cap stock indexes to keep up. This is due to the broader allocation to sectors and lower natural levels of technology stocks in small cap indexes.  This is also due to momentum; when trends occur, the S&P 500 Index, due to its lower amount of stocks, can participate more in explosive and momentum-based trends than a more broadly diversified index made up of more stocks and a more diversified mix of sectors.

The S&P Small Cap 600 Index holds far less technology stocks than the S&P 500 Index

https://www.spglobal.com/spdji/en/documents/research/research-celebrating-30-years-of-the-sp-smallcap-600.pdf

On a related note, investors seeking to mitigate the risks of concentration in the S&P 500 Index may be thinking of switching to an equal-weighted index. However, this, in effect, is just buying more smaller-cap stocks and fewer technology stocks, which sounds like the same thing as just adding small-cap stocks to an existing portfolio.

Lessons from the Dot-Com bubble

Some may say that the AI revolution looks and sounds a lot like the internet revolution. Many market-related factors are the same; a thematic technology story, concentration in technology stocks in the S&P 500 Index, and S&P 500 Index leadership are all in similar states.

But market cycles turn. And when they do, the snap-back can be fierce.

• Once the shine came off the internet stocks, small-cap stocks consistently outperformed large-cap stocks across almost every five-year period for almost 20 years.
• Small-cap stock provided this outperformance through critical negative time periods.
• Since January 2000, near the peak of the Dot-Com bubble, small-cap stocks as represented by the S&P 600 Index have handily outperformed the large-cap S&P 500 Index.

S&P 600 Small Cap Index vs. S&P 500 Large Cap Index – 20 Years Ending 2019

Undervalued and on sale

Today, large-cap valuations are stretched, while small caps are trading at a significant discount. It’s a classic case of market mispricing.

The S&P 500’s forward price-to-earnings (P/E) ratio currently sits around 24x. In stark contrast, the quality-screened S&P 600 trades at a forward P/E of approximately 16x, a significant discount that approaches levels last seen during the Global Financial Crisis. Furthermore, the earnings growth of the S&P 600 Index is expected to be higher than that of the S&P 500 Index.

P/E: MacroMicro “US – S&P 600 – Forward PE Ratio.” Data as of December 31, 2025.
Earnings: YCharts “S&P 500 P/E Ratio Forward Estimate.” Data as of December 31, 2025.

Why the sudden opportunity?

The above valuation difference has been exhibited for some time now, and the same can be said of many other asset classes when compared to the generationally overvalued S&P 500 Index. So, why now? What is going to change?

• The Fed pivot: Small caps are more sensitive to interest rates. As the Federal Reserve signals continued rate cuts, the primary headwind holding them back is poised to become a tailwind.
• Earnings growth: This is the most compelling argument. Analysts are projecting an acceleration in earnings for small-cap companies.
• Alternatively, a catalyst could be large-cap tech stocks losing steam, for no apparent reason. This is what happened during the Dot-Com correction.

While the “Mag 7”^‡ and technology leaders of the day dominate headlines, the real opportunity might just be hiding in plain sight. For investors willing to look beyond the hype and focus on quality (the S&P 600, not the Russell 2000), the potential for a small-cap renaissance has rarely looked better.

Frontier holds positions in small-cap stocks, maybe more so than some competitors, but our positioning is measured and reasonable. We also hold active managers that can adjust their funds in an effort to take advantage of these types of opportunities. Time will tell whether small cap stocks live up to their potential, but for now, they appear to be an opportunity for added value.

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^‡Apple (AAPL), Microsoft (MSFT), Alphabet (GOOGL), Amazon (AMZN), Meta Platforms (META), Nvidia (NVDA), and Tesla (TSLA).