Five Reasons Why You Should Invest In Small Caps Right Now

S&P 500 or Russell 2000 Stocks: Which is a better buy?

Over the last 24 years, small-cap stocks have generally outperformed large-cap stocks; 2023 and 2024 marked a comeback for large-cap. However, the tides are shifting again in small caps’ favor thanks to the Fed’s easing monetary policy and the possibility of a more substantial small-cap economic landscape under the incoming administration.

While small-caps have lost some of their gains, they are still outpacing large-cap stocks on a trailing one-month basis. The small-cap heavy Russell 2000 Index (RTY) and the S&P Small Cap 600 Index (SP600) have rallied around 11% over the past 12 months, while the iShares Russell 2000 ETF (IWM) vs. S&P 500 (SP500) have also steadily notched new gains over the past year.

iShares Russell 2000 ETF (IWM) vs. S&P 500 (SP500) 6-month Trading Chart

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By comparison, the S&P 500 (SPX) – while still up nearly 24% YTD – has shed key gains in recent weeks, while the large-cap heavy Dow Jones Industrial Average (DJI) – up almost 13% YTD – has shaved off a little over a percentage point since the election.

Dow Jones Industrial Average (DJI) vs. S&P 500 (SP500) 1-month Trading Chart

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Small caps and large caps each come with pros and cons. Small-cap stocks have been shown to generate higher returns in the current rate environment at better valuations but are often accompanied by higher risk profiles. Large-cap stocks usually exhibit less growth but can frequently be stable. With the sustained small-cap rally on track to continue into 2025, this article aims to explain why small-cap stocks are often better positioned for success given the current macroeconomic backdrop.

Small-Cap Stocks: The Gift That Keeps on Giving

Good things come in small packages, so the saying goes this time of year. Nowhere is that sentiment better reflected than in the stock market.

As discussed when I mapped out my Top 10 Small Caps For 2025 last week, small-cap stocks tend to thrive in a low interest rate environment because they typically hold higher debt burdens than large caps. In other words, small-cap companies often post better earnings due to lower rates because it costs less for them to borrow. Small-caps have been rallying since the Fed’s initial rate cuts in September and have gained even further momentum following Donald Trump’s presidential victory, as investors bet on the incoming administration’s more protectionist fiscal policy and aggressive tax cuts to boost the domestic economy–particularly smaller companies.

The Fed Cuts Rates: Just in Time for Christmas

The Federal Reserve slashed interest rates by 0.25% on Wednesday following a recent report by the Bureau of Labor Statistics showing that inflation rose 2.7% in November–broadly in line with analysts’ expectations. That lingering inflation, coupled with promising data on the US job market released by the BLS earlier this month, indicated that the Fed is embracing a slow and steady approach to rate cuts in the new year.

My top five small-cap stocks from November returned over 20% since November 25, beating the S&P 500 and the small-cap Russell benchmark. Seeking Alpha’s Quant System can help analyze top stocks across the S&P 500 and Russell 2000 to illustrate the benefits of small caps in the current market, providing an extra layer of analysis beyond the top small-cap stock screener available to SA premium subscribers. Looking at the chart below, from 10/2/2023 to 12/13/2024, popular small-cap indexes – including the SPDR S&P 600 Small Cap Value ETF (SLYV) – rallied about 31% on average.

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If small caps continue to surge, I’ve mapped out five reasons why it could be worth buying stocks from the Russell 2000 index versus the broader S&P–in 2025.

Five Reasons to Invest in Small Caps Today

1. Small caps are subject to less concentration risk. The top 10 stocks in the S&P 500 account for just under 40% of the entire index, eclipsing the 27% seen during the dot-com bubble in 2000 – its highest concentration level in decades. Moreover, the top three stocks in the S&P 500–Apple (AAPL), Microsoft (MSFT), and NVIDIA (NVDA) –represent over 20% of the index, the highest concentration on record.

JPMorgan Asset Management

 

This raises alarm bells for several reasons. Take NVDA, for example. The chipmaker has returned more than 160% year-to-date and fueled around 20% of the S&P’s gains amid explosive demand for graphics processing units, becoming the go-to AI components for tech giants including Meta (META), Microsoft, and more. But the semiconductor darling, which has gained 853% since the launch of OpenAI’s ChatGPT chatbot in November 2022, has lost momentum recently. Shares have been down more than 13% since its record close at $148.87 per share on November 7, 2024. Shares have fallen nearly 6% over the past month since the S&P’s 3% rise and -0.45% over the past six months compared to the S&P’s near 11% increase.

NVDA’s shifting fortunes risk exploding vulnerabilities in the broader market, especially indexes heavily weighted to Nvidia, like the S&P 500. Big Tech companies, including Apple–which has reportedly joined forces with Broadcom (AVGO) to develop AI chips—are threatening NVDA’s market dominance.

A key advantage of investing in small caps in the current market is that small-cap indices have far less concentration risk. Take the small-cap-heavy Russell 2000 index. According to a study by the London Stock Exchange (LSE), the Russell 2000 contained more than ten times the number of actively moving stocks than its large-cap-focused Russell 1000 index, even though the Russell 2000 has only twice the amount of stocks as the Russell 1000.

An index’s “effective” number of stocks refers to how many listed companies contribute to its overall movements. In other words, the less “effective” stocks an index has, the more concentrated the index is.

The LSE found that the Russell 1000 has recently registered the lowest “effective” number of stocks since its inception in 1978, indicating it’s more concentrated than ever.

Russell 1000 Index, London Stock Exchange

 

SA Quant’s Top Semiconductor Stocks below reveal that several small-cap companies, including Rigetti Computing (RGTI), Sequans Communications (SQNS), and SkyWater Technology (SKYT), all retain higher Quant ratings than NVDA, which has remained at ‘Hold’ status after falling from a ‘Strong Buy’ in mid-November.

SA Quant’s Top Semiconductor Stocks as of 12/19/24

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2. Large-cap stocks are extraordinarily overvalued. In addition to large-cap stocks carrying higher concentration risk, recently, they’ve been accompanied by frothier valuations. The S&P 500 currently holds a forward price-to-earnings (P/E) ratio of 22.3, topping that of the 5-year (19.6), 10-year (18.1), 15-year (16.4), 20-year (15.8), and 25-year (16.4) historical averages, according to FactSet Research. Most notably, the index has only risen above 22 two times since 1985: during the dot-com bubble and the Covid-19 pandemic in April 2021.

That’s a significant premium to the five-year average of 19.7x forward earnings and the 10-year average of 18.1x forward earnings. Examining forward P/E multiples of the Magnificent Seven market-moving stocks reveals even higher figures. These figures suggest that the S&P’s most prominent companies are overvalued and further contribute to large caps’ concentration risk, eclipsing those of the other 493 stocks.

• Tesla (TSLA): forward P/E of 186.4x
• Amazon (AMZN): forward P/E of 45.42x
• NVIDIA (NVDA): forward P/E of 44.69x
• Microsoft (MSFT): forward P/E of 34.59x
• Apple (AAPL): forward P/E multiple of 33.95x
• Meta Platforms (META): forward P/E of 27.59x
• Alphabet (GOOG): forward P/E of 24.84

To grasp just how overvalued large-cap stocks have become, $100 invested in the Russell 1000 (large-caps) or Russell 2000 (small-caps) in the second quarter of 1987 would be worth $2,090 or $1,433 (+1,900% or +1,333%) on December 6th, 2024, respectively.

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A closer look at the ratio between the two during this timeframe reveals a couple of interesting observations. Currently, large caps have outperformed by 46%. The last time such a gap favored the Russell 1000 was in the lead-up to the early 2000s Dot-Com Bust, when the value of internet-based companies plummeted following about a decade of exuberance.

The gap reached a maximum of 73% in 1999. What followed was 12 years when small caps closed the gap against their large-cap counterparts. In 2011, an original $100 invested in the Russell 2000 was up 10% against an equivalent in the Russell 1000.

Recent trends favoring large caps were almost entirely built up during and after the 2020 global pandemic, as the ratio climbed to 46% from 10% in Q4 2019. If a period of repricing occurs in 2025, the more this ratio rises, the more the risk-reward could favor the Russell 2000.

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3. Small-cap profitability has improved in recent years. While the number of unprofitable companies is higher than that of the S&P 500 or midcaps, it is well below crisis peaks like Covid-19 and the 2008 financial crisis. More than 41% of companies in the Russell 2000 are unprofitable, according to a July analysis by JPMorgan. Meanwhile, 17.5% of companies in the Russell MidCap index are unprofitable, versus 7.4% listed on the S&P 500. Adding to that risk is that small caps often take on more floating-rate debt, struggling to access many of the better rates afforded to large caps, which can hinder profitability when interest rates are elevated.

That being said, lowering interest rates and attractively low valuations of small caps compared to their large-cap counterpart are setting smaller companies on a path to higher profitability as small caps access cheaper debt, enabling them to improve company operations at a lesser cost to their balance sheets. The percentage of unprofitable small-cap companies has decreased from a 53% peak during the pandemic to 43% today.

JPMorgan Asset Management

 

4. Small caps have higher growth expectations than mid-to-large caps. Over the past 10 years, small and mid-cap companies have broadly posted more considerable earnings growth than large caps, according to JPMorgan. Most SMID-cap returns have been driven by earnings growth, as opposed to the multiple expansions driving the higher market caps of many of their large-cap peers.

Trailing 10-year EPS Growth CAGR and Annualized Return by Cap Size

JPMorgan Asset Management

 

What’s driving that earnings growth? Many small-cap companies are on the cutting edge of technological innovation, from AI to data centers to industrial automation. Small companies also have the advantage of being “big fish in a small pond,” JPMorgan notes, allowing them to gain an edge in niche and/or cyclical markets. They also make for ideal M&A targets: 96% of public M&A targets in the U.S. over the past three decades have been SMID-cap firms, according to JPMorgan, with the average premium that large-cap acquirers paid for SMID-cap companies reaching 50% in 2023, the highest level since the financial crisis.

5. Small caps stand to benefit from impending fiscal policy changes and the shifting political environment. Green flags from the Fed that it will continue slowly chipping away at interest have set the stage for more small caps to thrive. On top of that, as I wrote in November, Trump’s election is thought to have amplified the small-cap rally based on expectations that his policies will favor smaller companies. The Russell 2000 jumped over 5% following election day as investors placed bets that a more hands-off regulatory approach, corporate tax reform, and Trump’s proposed “America First” tariff policies could boost smaller domestic companies. Small caps have become one of the market’s big “Trump Trades,” alongside cryptocurrencies, the surging US dollar, and rising bond yields, among others–though it is still unclear how long these Trump rallies will last depending on how quickly the new administration implements its proposed policies.

Top Stocks: Small or Large Cap?

Now that we’ve discussed the potential upside and risks of small caps in today’s market, let’s compare a few stocks from the Russell 2000 and S&P 500 to see which is the better buy. We’ll use SA’s Quant system to pull the top stocks from each index.

First, let’s take a look at the Top Small Cap Stocks ranked by Quant. CTO Realty Growth (CTO), Travelzoo (TZOO), and Emergent BioSolutions (EBS) all rank in the top ten with ‘Strong Buy’ ratings. I’ve combined these with three ‘Strong Buy’ selections from SA’s list of Top Large Cap Stocks–Credo Technology Group (CRDO), Carnival Corporation (CCL), and United Airlines (UAL), and then ranked them by one-year performance.

Top Small and Large Cap Quant Stocks, Ranked by 1Y Performance as of 12/19/24

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3 Small Cap Stocks

1. Emergent BioSolutions Inc. (EBS)

• Market Capitalization: $442.1M
• Quant Rating: Strong Buy
• Quant Sector Ranking (as of 12/19/24): 5 out of 1022
• Quant Industry Ranking (as of 12/19/24): 2 out of 502

EBS is a small-cap Maryland-headquartered biopharmaceutical group that develops treatments for infectious diseases and opioid overdoses. EBS has ‘A+’ Valuation, Growth, and Momentum grades. Its forward price-to-sales ratio of 0.4 is well below the sector median. It indicates an 89% discount, while its working capital growth of 659.68% is well above the -6.29% sector median, suggesting it is investing heavily in its next growth phase. Emergent BioSolutions received a $50m contract option this week from the US Department of Health and Human Services’ Biomedical Advanced Research and Development Authority for its anthrax vaccine CYFENDUS®.

2. CTO Realty Growth, Inc. (CTO)

• Market Capitalization: $581.5M
• Quant Rating: Strong Buy
• Quant Sector Ranking (as of 12/19/24): 3 out of 180
• Quant Industry Ranking (as of 12/19/24): 1 out of 14

CTO is a real estate property group ranked among my top 5 REITs in October. It maintains a ‘Strong Buy’ label due to its fundamentals, attractive yield of 7.40%, and consistent outperformance of its peers. The Winter Park, Florida-based company holds the top spot among Diversified REITs, and agreed to acquire Tampa-based grocery chain Granada Plaza this week for $16.8M.

Helping uplift its ‘A’-rated valuation and ‘A+’-rated Dividend Yield Grade is its 4-year average dividend yield of 12.76%, a 197% difference to the sector, as well as its 7.84% trailing dividend yield, a 75.84% difference to the sector. CTO also maintains positive growth metrics: AFFO FWD growth of 4.2% and a FWD EBITDA growth of 23.6%, which are +159.6% and +422% above the sector median, respectively.

3. Travelzoo (TZOO)

• Market Capitalization:
• Quant Rating: Strong Buy
• Quant Sector Ranking (as of 12/19/24): 1 out of 233
• Quant Industry Ranking (as of 12/19/24): 1 out of 59

TZOO, one of my top 10 small-cap stocks for 2025, comes fourth in terms of one-year performance. Ranked first among Top Communication Stocks and Top Interactive Media and Services Stocks, the travel deal site exhibits solid growth prospects, with forward revenue growth of 11.79% (a 486.33% difference to the sector median), forward EBITDA growth of 27% (an 844.73% difference) and YoY EBITDA growth of 14.7% (a 1,882.06% difference). Profitability is also solid, within 81.5% (TTM) total return on capital (a 1,949.69% difference to the sector), a 27.8% (TTM) total return on assets (a ​​1,543% difference), and an asset turnover ratio of1.59x (a 223.7% difference).

With A’s across the board regarding its Momentum Grade, TZOO has posted consistent performance over the past year, eclipsing its sector rivals by nearly 6.3446% in terms of 6-month price performance.

TZOO Performance as of 12/19/24

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The large caps are next in terms of 1Y performance, and the top contender on my list is the large-cap networking solutions company CREDO.

3 Large Cap Stocks

1. Credo Technology Group (CRDO)

• Market Capitalization: $11.1B
• Quant Rating: Strong Buy
• Quant Sector Ranking (as of 12/19/24): 3 out of 538
• Quant Industry Ranking (as of 12/19/24): 2 out of 66

The Bay Area-based group “is poised to benefit from a multi-year scale-out in the custom data center infrastructure markets over the next 3 years,” thanks to the AI boom in Silicon Valley, writes SA analyst Uttam Dey, with ‘A+’ growth prospects including forward revenue growth of 49.68% and forward EBITDA growth of 129.08%. The group also exhibits excellent momentum and a solid valuation, with a price-to-earnings growth (PEG) ratio of 1.4x.

Underpinning CRDO’s ‘A+’ Growth Grade are YoY revenue growth of 48.4% (a 991.8% difference to the sector), forward revenue growth of 49.7% (a 772.1% difference), forward EBITDA growth of 129.1% (a 2,156.9% difference) and forward EBIT growth of 171.8% (a 2,023.5% difference) among other standout metrics.

However, CRDO’s ‘D’ Profitability Grade weighs down its overall quant score, the lowest rating in that category among the six selections, due to its -7.96% EBITDA margin among other low scores.

2. United Airlines Holdings, Inc. (UAL)

• Market Capitalization: $30B
• Quant Rating: Strong Buy
• Quant Sector Ranking (as of 12/19/24): 7 out of 616
• Quant Industry Ranking (as of 12/19/24): 2 out of 26

Included among my top five growth stocks earlier this month, United Airlines has returned nearly 123% over the past 12 months, soaring on substantial revenue gleaned from its credit card program and other non-airline revenue streams.

Ranked the #2 Quant pick in the Passenger Airlines industry, UAL’s ‘A+’ Momentum Grade reflects surging price performance of 129% YTD, exhibiting significant growth versus the sector. UAL has received 13 positive EPS revisions in the last 90 days. Of the 19 analysts offering EPS estimates, the consensus is that UAL could achieve EPS of $12.4 by December 2025 – representing 20.4% in YoY growth.

Forward non-GAAP P/E of 8.9x and a forward price-to-cash flow ratio of 3.92x are just a few of the promising value metrics that have landed UAL on JPMorgan analysts’ latest list of value picks.

3. Carnival Corporation & plc (CCL)

• Market Capitalization: $32B
• Quant Rating: Strong Buy
• Quant Sector Ranking (as of 12/19/24): 1 out of 484
• Quant Industry Ranking (as of 12/19/24): 1 out of 34

Large-cap leisure industry behemoth CLL ranks fifth in terms of 1Y performance with ‘A’s across the Quant scoreboard as it prepares to ride the wave of cruise demand in 2025, with FQ4 EPS estimates of $1.72, up 28.9%, and revenue estimates of $26.1 billion, up 4.5%. Included among my Top Black Friday Deals last month and ranked first among Consumer Discretionary Stocks and Hotels, Resorts, and Cruise Line Stocks, CCL continues to be a solid bet in terms of valuation, profitability, growth, and momentum. In other words, this isn’t one of those overvalued large caps you need to worry about.

CCL Quant Factor Grades as of 12/19/24

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With A’s across the Quant board, CCL boasts impressive past performance and also holds indicators for future performance, including forward revenue growth of 29%, an 842% difference to the sector, and an EPS estimate for November 2025 of 1.73x, which would represent more than 28% YoY growth.

Should I buy small-cap stocks?

While these six examples used for this sample portfolio by no means reflect the market as a whole, they do illustrate that some high-performing small-cap stocks on the Russell 2000 compete with top stocks on the S&P 500. Investing in smaller companies can be a great way to complement a diversified portfolio as interest rates continue to lower gradually.

Stockpicking is highly situational, but SA’s Quant algorithm can help identify the most profitable small caps with outsized performance and growth potential. It can also identify large caps with strong financials and filter out overvalued ones.

Small-caps tend to benefit from a lower-rate environment due to cheaper borrowing costs, a risk-on sentiment, and enhanced growth potential. These market factors and bullish sentiment favoring more business-friendly policies under Trump are poised to keep the spotlight on small caps into the new year.

Seeking Alpha Quant Ratings and Factor Grades can help investors deal with uncertainty by presenting solid quant-vetted stocks. The SA Quant team’s top small-cap stocks are ranked based on various factors, including growth, momentum, valuation, and profitability. In addition to small caps, if you’re seeking a limited number of monthly ideas from the hundreds of top quant Strong Buy rated stocks, the Quant Team’s best-of-the-best, consider exploring Alpha Picks. This service highlights the best-performing stocks from hundreds of top-rated Quant Strong Buy options, offering actionable ideas to help elevate your portfolio.

This article was written by: Steven Cress, Quant Team