What could drive U.S. small cap returns in 2026?

Jonathan Coleman: I think there are going to be a number of drivers to small-cap performance in 2026.  First, I would say there’s a common belief that small caps need lower interest rates to outperform. We actually look back in history and history would tell you that that is not the case. In fact, the single best decade of performance in the history for small caps in the U.S. market was the period of the 1970s that was kind of characterized by higher inflation and higher interest rates for longer. Additionally, the first decade of the 2000s was a period where interest rates were increasing, and small caps did very well relative to large. So, we actually don’t think necessarily that small caps need lower interest rates to perform.

But let’s also talk about a couple other drivers that might happen in 2026. One would be the long-term trend that we’re now four or five years into that we’re seeing towards reshoring. Small-cap companies have a much larger percentage of their revenues derived from domestic sources than do large caps, and so we think that will be beneficial to small-cap companies.

We also are seeing a pick-up in M&A, particularly in certain pockets of the market. One that I would highlight would be biotech, where this fall, we have seen quite a flurry of activity as large pharmaceutical companies are looking to diversify their pipelines and deal with patent expiries that they have that are on the horizon.

And then lastly, I’d say the IPO market is picking up after kind of a long slumber. We had a peak in IPOs in terms of recent history around 2021, and we went into a very significant trough, but we’re starting to see that accelerate now. And what is exciting to us is that after a period where the IPO market is closed, it is often the highest-quality companies that are able to come public first. And so that has been a fertile ground for new ideas.

One of the things we’re finding in terms of compelling opportunities more broadly in small caps is that actually earnings growth is more closely approximating that of large-cap companies for small-cap companies. So, we’ve seen that late this year and we expect that to continue into 2026.

We’re seeing other pockets of opportunities in areas like industrials. We’ve talked about the reshoring opportunities. There’s a lot of infrastructure buildout that will occur as a result of that. There’s obviously a lot of discussion of AI and data center buildouts; those are pockets of opportunity. I think you need to be careful about valuations in some of those spaces, because there’s a lot of excitement and perhaps exuberance in some of those areas. But we are finding interesting opportunities at reasonable valuations for companies that we think will have great secular growth opportunities.

I think the underappreciated risk if there … is that there are pockets of the market that are showing true signs of overexuberance and even irrationality, I would say. And so, we’re seeing some companies in areas like quantum computing, some areas associated with AI, eVTOLs, which are flying electric vehicles, where many of the companies don’t yet have revenues and yet have very large market capitalizations. And so, when we look at the broad landscape, we think it is a time to be careful.

But there are many companies that are trading at very rational P/E multiples. So, we really think it’s a time for active management versus passively buying the index.

We think an important takeaway for investors who are considering small caps would just be that history I think is on our side. As we think about an increased allocation to small caps, the diversification benefit that they would give you, particularly with the backdrop of small caps having underperformed large caps for about the past 14 year, history would tell us that that trend will shift, and we’re starting to see some elements that that is the case. In fact, the small-cap market returns have been roughly equivalent to the S&P since about mid-year. And so that’s encouraging to us.

Additionally, the starting point really matters. And so, valuations of small caps are historically cheap compared to large caps. They’re at about long-term averages on an absolute basis, but relative to large caps, they’re historically cheap because of this decade-plus of underperformance.

And then lastly, we actually believe that small-cap companies could be the disproportionate beneficiaries of AI investments and the AI revolution. Because we all, I think, share a belief that AI could bring productivity gains and margin expansion opportunities to all companies once they are deployed.

I kind of call this the second-order effect of AI. The first order effect is building out AI capabilities. The second will be the companies that are utilizing AI to make their companies more efficient and more productive. But the starting point really matters, and so small-cap companies have much lower profitability than large-cap companies do, and in fact average operating margin for a small-cap public company in the United States is about 6%. The similar average for a large-cap company is 18%.

So, if we agree that AI productivity gains could expand operating margins by about two percentage points, or 200 basis points, for the average company, that would be a one-third increase in earnings for the typical small cap company, where it was, whereas it would only be an 11% increase for the large cap company. And so, I think when the final chapters of the AI book are written, my belief is that we could look back and actually find that small companies disproportionately benefited. And so that’s I think a really intriguing opportunity to consider for the next three, five, and 10 years.