The small-cap stock market dances to its own dynamic and oftentimes tumultuous rhythm. Here's what you need to know in mid-2025 to make smarter small-cap investing decisions.

Current Dynamics

Small-caps continue to battle the market titans for their share of investor interest. Small company stocks continue to underperform as they have in much of the past decade—especially in 2023 and 2024. Both the Russell 2000 and the S&P SmallCap 600 have lagged behind their larger counterparts in the S&P 500 for most of the recent past. Much of the dimmer light shone on small-caps is due to mega-cap tech stars (the “Magnificent Seven”) hogging the spotlight and siphoning investor enthusiasm.

Many of the historical trends and drivers that boost small-caps have not materialized in the last few years as they have done historically. This does not mean that there have been any systemic deviations to the general dynamics of the market, but rather, in my view, that the market and the economy are in the midst of longer-than-average cycles.

For instance, small-cap firms often ride the credit wave, but they are seen as more precarious borrowers that can be impacted by soaring borrowing costs. With the Federal Reserve’s relentless interest rate hikes aiming to tame inflation, smaller companies have faced rising borrowing costs that can stifle growth and trim profitability. A notable share of Russell 2000 companies are living in the red. Many also carry significant debt that is due to mature soon, exposing them to the choppy waters  
of refinancing at potentially steeper rates.

Within our SCI coverage universe, most stocks that we follow carry low or modest levels of debt. Our covered companies in industries that traditionally rely on debt financing (such as real estate) share a disciplined approach to borrowing. We far prefer for our companies to not get caught up in morasses of debt and interest payments, so our style of company selection helps reduce risks that come from interest rate fluctuations.

Lower rates could act as a tailwind for many small-caps, brightening prospects as borrowing becomes cheaper and economic activity stirs. The possibility of rate cuts is influencing market sentiment like a pendulum, swinging back towards optimism.

Inflationary pressures remain another area of concern in mid-2025: With wages climbing and inflation rates continuing to be problematic, small-cap earnings can quickly come under siege. Unlike the seasoned giants of industry, small-caps sometimes lack the muscle to easily pass rising costs onto consumers—fearing a backlash in demand.

However, some small firms dominate underserved or niche markets, bestowing them a surprising leverage to set prices amid inflationary pressures, helping defend profit margins. Monitoring profit margins remains a proactive method for investors to keep tabs on how companies are managing their expenses from quarter-to-quarter.

In recent years, it has sometimes seemed that investing in small company stocks is an age-old fairy tale story of of unrequited love. While large-cap stocks bask in the glow of analysts, small-caps often languish in the shadows, attracting much less institutional interest. This is understandable since it is either impractical or outright prohibited for large mutual funds to hold small-cap stocks in any meaningful measure that would support the price growth of these securities.

On the upside, this obscurity leads to inefficiencies in pricing, creating golden opportunities for shrewd investors. While mega-cap tech stocks have now long held the reins, signs of diversification are bubbling up. When concentration relaxes, small-cap stocks will likely take to center stage and shine.

Recent concerns about U.S. global trade policies help create home turf advantage for small companies. Small-scale businesses thrive on domestic soil, generating most of their revenues within the U.S. This focus makes them sensitive to local economic ebbs and flows while shielding them, to some extent, from many of the global trade uncertainties that plague their larger competitors.

Likewise, steady and resilient U.S. consumer spending lays a solid groundwork for many small-cap companies. Their domestic focus positions them to seize opportunities amid improving local economic winds.

The wave of supply chain localization—the pushing of industries back onto home ground, or “onshoring”—is gathering momentum. This trend bodes well for small-cap manufacturers who thrive in a domestic-centric landscape.

Small-cap enterprises often inhabit the vibrant realms of emerging industries—biotech, fintech, renewable energy. Their nimbleness and innovative spirit mean they adapt swiftly, sliding into new technologies and market trends like second nature.

From a valuation perspective, U.S. small-cap stocks continue to trade at remarkable discounts compared to large-caps, even hitting multi-decade lows. Historically, small company stocks commanded premiums, making the present valuation gap a potential treasure trove for discerning investors.

Small businesses do attract the attention of larger market players and private equity investors, and thus can find themselves at the heart of acquisition discussions. While we have seen companies in our coverage list snapped up by buyers or merged with other businesses, I am surprised that more mergers and acquisitions do not occur. The current higher-rate environment could stifle the appetite for some deals, it is true But the possibility of buyouts remains distinct for many small company stocks.

Trends and Forecast

At the risk of sounding like a scratched record, the future for small-cap stocks in 2025 remains mixed, with both challenges and glimmers of hope.

Potential tailwinds include anticipated rate cuts. Even speculation about the timing of lower rates stirs excitement. History shows that small-caps often excel in the wake of the first rate drop.

With the current substantial gap between small-cap and large-cap valuations, an enticing opportunity still remains as earnings improve and markets take notice.

A resilient U.S. economy, alongside the prospect of a "soft landing," could shield small-caps from the worst of the market’s storms, fostering a nurturing environment for growth.

Continued and accelerating merger and acquisition activity is poised to benefit small companies, appealing to investors looking for underappreciated gems.

When the market shifts away from large-cap tech dominance (as it ultimately, eventually must do), capital may then flow back to smaller players, expanding the reach and influence of these small-caps.

Though volatility is often viewed with caution, it opens doors for active stock investors to uncover hidden gems. Being prepared to “buy on the dip” continues to be a viable strategy when deployed on high-quality companies.

Consensus forecasts predict stronger earnings for the small company stocks of the Russell 2000 in 2025, highlighting a potential rebound from recent earnings lulls.

Potential Headwinds and Risks

Resurgent inflation worries could cloud the outlook. Maintaining higher borrowing costs could weigh on performance for some companies.

A pause in real GDP growth in 2025 could stifle corporate earnings growth, putting further pressure on small-caps.

Trade tensions and political strife—complete with tariff threats—can dampen economic growth and sour small-cap investor sentiment.

Despite early signs of broadening interest in stocks other than mega-caps, the ongoing rule of large-cap tech firms could overshadow small-cap potential for the foreseeable future.

While recession fears have eased, they linger as a threat. Small-cap firms often face tougher circumstances during downturns due to their limited resources.

Conclusion

Although small-cap stocks have weathered significant storms recently, many analysts believe a resurgence could be on the horizon for 2025 or 2026. A confluence of inviting valuations, anticipated interest rate cuts, and potential market rebalancing could craft a more favorable backdrop.

However, investors are advised to remain vigilant, considering the inherent volatility and risks within this asset class.

As always, a selective, long-term approach focusing on quality companies with robust fundamentals and stellar management could yield illuminating returns.
 

Stay the course!

• DOUG GERLACH

Subscribers can read Doug's complete commentary and the in-depth profile of our recommended small company stock in the current issue of the SmallCap Informer stock newsletter. Not a subscriber? Subscribe to the SmallCap Informer and get monthly small company stock recommendations and updated buy/sell prices for each of the 40+ high-quality small company stocks currently covered in the newsletter.