By Spencer Jakab

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Most investors believe yesterday's Federal Reserve decision will be good for stocks, but a falling rate doesn't lift all boats equally: Small ones tend to benefit more, and they have plenty of catching up to do.

In August, when the odds of a rate cut began rising, small-capitalization stocks got a jolt. After trailing the S&P 500 by 17 percentage points in the preceding 12 months, the small-cap Russell 2000 index beat it by five points in August.

Truist Securities noted last month when upgrading its view on small companies that, on a rolling three-year basis, their performance versus large ones had shown the "most extreme divergence" in nearly a quarter century.

Northern Trust Asset Management's Daniel Fang said in April that small caps have tended to lag behind large caps for around nine years on average. Their latest slump has lasted 12, over which time the S&P 500 has outperformed them by a whopping 216 percentage points.

A reversal in fortunes could well be sparked by this easing cycle because of how firms finance themselves. Smaller companies tend to have more floating-rate bank loans and shorter-term debt in general. When the Fed hiked in 2022, small companies were more likely to feel strains than large ones that had locked in longer-term, fixed-rate borrowing in the bond market.

Not everyone is salivating, though, including at least one specialist who should be talking its book. Small-cap, value-focused Palm Valley Capital Management says the broad Russell 2000 still isn't cheap.

A high proportion of small-cap companies lose money, and many of the best were taken private or gobbled up by competitors during the era of ultra-low rates. While Palm Valley is buying stocks selectively, the firm noted in its last letter that the median price-to-earnings ratio of a profitable company in the S&P 600, another small-cap index, was 19 times.

That doesn't sound extreme compared with the S&P 500, and especially with the large tech companies that have powered the index's gains. But it is no screaming bargain either.

If this easing cycle is the time to raise exposure to the neglected small-cap category, then some pickiness is in order. One simple way to adjust for money-losing companies in an index is to use a multiple of price-to-sales.

On that basis, the S&P 600 Value index sports around half the multiple of the more widely followed Russell 2000 and can be bought as an ETF. The Russell index is, in turn, 60% cheaper on the same basis than the S&P 500 (some discount is warranted since large caps have much higher profit margins).

Small and cheap, not just small, may be the way to benefit most from this easing cycle.

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(END) Dow Jones Newswires

September 18, 2025 11:30 ET (15:30 GMT)

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