By Paul R. La Monica

Good things may come in small packages, but that hasn't been the case for investors in small-cap stocks until recently. Can the rally last?

The Russell 2000 has had an amazing August. The index has gained 7.5%, more than double the return on the Dow Jones Industrial Average and nearly triple that of the S&P 500. The rally in small-company stocks was kicked into overdrive after Fed Chair Jerome Powell's dovish speech at Jackson Hole on Aug. 22, and the talk is now of how small can outperform large for the foreseeable future.

We've heard that one before. In fact, there have been numerous head-fake rallies for small-cap stocks in the past few years that left investors smarting after selling their Big Cap Tech and moving down in size. This recent surge in small-caps seems different. The odds of a September interest-rate cut -- and more to come -- have shot up after Powell's speech, and lower rates could support the U.S. economy, which is good news for smaller companies that tend to have more of a domestic focus than the multinationals in the Dow and S&P 500. Small-caps also have higher levels of floating-rate debt, so they can get a boost from lower interest expenses. Fiscal stimulus from the White House and Congress should help too.

"Any whiff of real rate relief is a tailwind for small-caps and their growth," says Brian Mulberry, a client portfolio manager with Zacks Investment Management.

This could be just the beginning of a turnaround. Chris Shipley, co-chief investment officer with Fort Washington Investment Advisors, points out that the combined market capitalization Russell 2000 companies is a little below 5% of the overall value of the Russell 3000 index, which also includes mid- and large-caps. Typically, small-caps make up around 7% to 10% of the broader investing universe, so Shipley sees room for upside.

The trick, however, is to try to avoid smaller companies that are expected to lose money, such as start-ups in tech and biotech. Mulberry recommends several consumer-oriented companies with "unique niches," such as K-12 online learning company Stride, gas station and convenience store operator Murphy USA, and the iconic New York-based concert and sport-venue owner Madison Square Garden Entertainment. All three look reasonably valued, with Murphy USA trading at 16 times earnings estimates for this year while Stride and MSGE have forward price/earnings ratios in the low 20s.

Tim Skiendzielewski, a portfolio manager overseeing small- and mid-cap strategies for Rockefeller Asset Management, also thinks small consumer stocks look attractive. He recommends discount retailer Ollie's Bargain Outlet, plant-based milk maker SunOpta, and pawnshop operator FirstCash, a recent Barron's stock pick. Skiendzielewski says there are bargains as well in smaller software stocks, noting that banking software firm Q2 and Agilysys, which develops software for the hospitality industry, have been oversold like megacaps such as Salesforce and others in the sector due to concerns about artificial intelligence eating into growth.

And growth is what matters. Skiendzielewski says that with earnings for the Russell 2000 expected to increase by 30% this year and continuing to rise in 2026 after falling in 2023 and 2024, small-caps finally have the kind of fundamental momentum that used to be exclusive to larger techs. Also helping? Merger activity is starting to pick up. Gildan Activewear just agreed to buy HanesBrands for $4.4 billion, for example. "The hot M&A market should buoy multiples. Small-caps have better earnings growth than the broader market and are still trading at a discount. It's a perfect storm," he says.

We agree. Small-caps are ready to shine at long last.

Write to Paul R. La Monica at paul.lamonica@barrons.com

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August 29, 2025 01:30 ET (05:30 GMT)

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