By Teresa Rivas

Small companies' stocks have had big problems for years. That will change -- eventually.

The stock market rally in 2023 and 2024 was mostly propelled by the Magnificent Seven megacap tech stocks -- to the point that smaller companies weren't on many investors' radars. But the issue goes back much farther than that. Although investing cycles wax and wane, it has been more than a decade since small-caps have outperformed the broader market, nearly any way you slice it. The S&P 500 is up some 164% in the past 10 years, compared with an 81% gain for the Russell 2000 and a 71% gain for the S&P SmallCap 600 index.

In short, it has been a long time in the wilderness for small-caps. And while there are potential catalysts on the horizon for the group, Craig Hodges, founder, CEO & co-chief investment officer of Hodges Capital Management says some of his favorite stocks still lie at the other end of the spectrum. He thinks it's still worth investing in small-caps -- with lots of patience -- while still having larger-cap exposure.

Hodges notes that the valuation gap between small-caps and the broader market is stretched -- making it hard to predict when this cohort of stocks will rebound. The S&P 500's price-to-earnings ratio is nearly 25 times, compared with just over 22 times for the S&P 600.

"We're in an unprecedented stretch of small cap underperformance, going on 15 years now," he says. "We don't know when we will be right about small-caps coming back but we are going to be and when it does, history shows it's pretty dramatic to the upside when it does happen."

Hodges Capital is no stranger to small-caps: It runs its Small Cap Fund under the ticker HDPSX and its Small Intrinsic Value Fund, ticker HDSVX, along with large and all-cap strategies. And because investors are nervous about stocks of all sizes -- given zigzagging policy out of Washington D.C. -- it can be hard to make the case for stocks in general, let alone small-caps.

"It's been remarkable to see the market turn on a dime," says Hodges. "We're dealing with headline risk from the administration...so I think a lot of investors have thrown up their hands and said, now is a decent time to be on the sidelines."

Some hopes for small-caps look unlikely in the near term -- like the idea of lower cost of capital going hand in hand with falling inflation and a friendlier Justice Department facilitating M&A. Nonetheless, there are other reasons to still like the category.

For starters, investors aren't hoping for much.

"This is the lowest expectations going into an earnings period I can think of, the bar is so low because there is no visibility out there," Hodges notes. That can lead to wild swings in the market, as we've seen, but also gives strong small-caps the chance to offer some positive surprises -- once investors feel they can put confidence in guidance.

Small-caps have also already felt a lot of pain, so much of the worst should be in the rearview mirror.

"In our small-cap world, these companies went through a pretty dramatic earnings recession in 2023, so you're starting to see a real resurgence in earnings estimates for small-caps," Hodges says. In fact, according to consensus data for the S&P 600 from Bloomberg, small-cap earnings per share growth is expected to surpass that of large-caps in the second half of 2025 for the first time since late 2022.

Put all that together and the picture could be brightening for small-caps. That said, Hodges notes that some of his favorite individual stocks are larger companies, like Barron's stock pick Uber Technologies, DraftKings, and Spotify Technology.

Other small-cap-focused managers also says hat there's still a case to be made for these companies, despite the broader economic uncertainty.

Charles Dreifus, portfolio manager of the Royce Small-Cap Special Equity Fund, argues that shares of auto-related companies like Advance Auto Parts and Standard Motor Products have been hit disproportionately hard due to tariff concerns. Likewise life sciences company Bio-Techne appears to have sold off excessively on worries about cuts to academic research given its long-term earnings potential, he says.

During 2025's market turmoil, the big tech darlings of last year's stock market rally have been hit even harder than the broader market. Investors shouldn't discount the possibility that when some normalcy returns, those megacaps could share some of the spotlight with their smaller cousins.

Write to Teresa Rivas at teresa.rivas@barrons.com

This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.

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April 30, 2025 13:57 ET (17:57 GMT)

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