For Financial Professionals in the US

The value of small caps for the road ahead

Portfolio Managers Justin Tugman and Craig Kempler explain how the current state of small caps and a defensive value approach complement the market environment they expect in the coming years.

Justin Tugman, CFA

Justin Tugman, CFA

Portfolio Manager, Team Leader

Craig Kempler, CFA

Craig Kempler, CFA

Portfolio Manager

Mar 21, 2023
4 minute read

Key takeaways:

  • Market upheaval during the past 16 months has left small caps more reasonably valued and reduced their share of the overall market to uncommon levels. Though the inflation that set markets reeling remains elevated, we expect it to moderate as tighter monetary policy takes hold.
  • Historically, these conditions – low relative valuations, decreased representation in the overall market, and a setting of elevated but falling inflation – have preceded periods of relative small-cap outperformance.
  • Within the asset class, we believe investors should focus on reasonably valued companies that are defensively positioned for a world of more expensive, scarcer capital and more difficult economic conditions.

The past 16 months have left us with a radically changed small-cap picture, providing investors with an opportunity to reevaluate the outlook for the asset class. Previously, higher-risk, higher-valuation, and more speculative stocks generally led small caps higher and resulted in them trading at extreme valuations, fueled by historically low interest rates. Now, a new regime of significant tightening from the Federal Reserve (Fed) has significantly reset the small-cap market, changing future expectations considerably.

Small has gotten smaller, providing room to grow

Over the past year, small-cap valuations have moderated to more reasonable absolute levels. However, compared to large-cap stocks, relative valuations of small cap stocks are at levels that have historically presented attractive investment opportunities. This readjustment in valuations has, in part, drawn down small caps’ representation in the overall market to uncommon levels, with small caps now making up less than 4% of the total equity market.

The last time small caps dipped to these levels was in 2020 (at the onset of the COVID pandemic) and, prior to that, during the Great Depression in the 1930s. When small caps dip below 5% of the total market, it has tended to be an impetus for outperformance in the following one-, two-, and three-year periods (Figure 1).

Figure 1: Small caps: percentage of total market and subsequent performance

  12M subsequent performance   24M subsequent performance   36M subsequent performance
Small as % of mkt Small Large Small vs large   Small Large Small vs large   Small Large Small vs large
Above 5% 14.0% 12.8% 0.8% 27.9% 27.0% 0.8% 42.9% 43.3% 0.5%
Below 5% 17.2% 10.7% 4.3% 37.2% 22.2% 10.8% 57.6% 32.1% 18.3%
Overall 15.5% 11.8% 2.4%   32.2% 24.8% 5.3%   49.5% 38.3% 8.5%


Past performance is no guarantee of future results. Source: Center for Research in Security Prices (CRSP®), The University of Chicago Booth School of Business; Jefferies LLC, as of Dec. 31, 2022.

Inflation −and its direction − can impact small-cap performance

Although inflation has moderated from peak levels in 2022, it remains − and we expect it to remain − elevated above the Fed’s 2% target for some time. That said, although it may take some time to make its impacts fully felt across the economy, we believe the Fed’s aggressive tightening will start to have its intended effect. An environment of elevated but falling inflation – which we expect in the coming years – has historically been an attractive setting for stocks in general, and specifically for small-cap outperformance compared to mid and large caps (Figure 2). This has not only been the case over one-year periods, but also for the forward three- and five-year periods.1

Figure 2: Annual performance by market cap in different inflation environments

Past performance is no guarantee of future results. Source: Center for Research in Security Prices (CRSP), The University of Chicago Booth School of Business; Jefferies LLC, as of Feb. 10, 2023.

What this means for small-cap investors

The current situation in small caps – more reasonable valuations, underappreciation in the overall market, and a backdrop of elevated but falling inflation − gives investors an opportunity to evaluate their portfolios. We believe now may be an appropriate time to consider allocating toward small caps, with the potential for a period of relative outperformance.

That said, within the asset class, we believe investors should be judicious and adopt an active approach with a focus on reasonably valued companies. A changed environment, with more expensive and scarcer capital and a more difficult economic backdrop, will require an increased emphasis on profitability, strong balance sheets, and proven business models.

As we’ve seen more recently, less profitable or nonearning businesses and those with weaker balance sheets tend to struggle when rates rise, and small-cap indices are populated with a significant portion of nonearning, more highly levered and unproven businesses. To that end, we believe an active approach can allow investors to focus on companies that are defensively positioned for the road ahead.

In our view, the current situation provides an attractive opportunity for investors with the appropriate risk tolerance to invest in small-cap stocks –particularly higher-quality small-cap value stocks – given what we see as enticing relative values in a market environment that could potentially experience a further contraction in valuation multiples.

1 Source: Center for Research in Security Prices (CRSP), The University of Chicago Booth School of Business; Jefferies LLC.

Quantitative Tightening (QT) is a government monetary policy occasionally used to decrease the money supply by either selling government securities or letting them mature and removing them from its cash balances.


Smaller capitalization securities may be less stable and more susceptible to adverse developments, and may be more volatile and less liquid than larger capitalization securities.

Actively managed portfolios may fail to produce the intended results. No investment strategy can ensure a profit or eliminate the risk of loss.