From AI ecosystems to industrial strength: The case for US small caps

The period spanning the second half of 2025 and the first half of 2026 marked a watershed moment for smaller US companies, as they outperformed their larger counterparts by some margin – putting the asset class firmly back on the map for investors.

The Russell 2000 index of US small-cap stocks outperformed the blue-chip S&P 500 index by more than 18% over this time – its strongest relative showing over a 12-month period in five years.¹

As of 19 August, the Russell 2000 was up 23% year to date, compared to the S&P 500’s 13% return over the same period.²

Small caps have at times been overlooked by some investors more focused on the so-called ‘Magnificent 7’, which are viewed as early artificial intelligence beneficiaries.

However, we believe the asset class has many positive qualities, including AI infrastructure exposure, robust growth potential, diversification and lower valuations.

The AI catalyst

A large part of the recent strength in small cap market performance has been driven by investor sentiment, including optimism around AI and its corresponding infrastructure buildout, along with more speculative opportunities in novel industries such as quantum computing or drone technology.

Over the past few months, the most overextended areas of momentum have experienced a sharp reversal, but the small cap market has held up well as investors rotated into underappreciated and oversold areas such as software.

Without a doubt many software businesses will be threatened by the rapid AI advancements, but many more that are quick to innovate and adopt AI technology will deepen their moats – an outcome we believe is underestimated by investors.

We view the recent market action as a healthy development, but we also believe the AI boom is far from over and small caps should continue to benefit as large technology firms spend hundreds of billions of dollars on AI infrastructure with many small companies on the receiving end of those investments. 

There are many smaller companies that operate in niche areas, from grid upgrades to specialised components for data centre construction, which should be well positioned to benefit over the coming years, creating potential opportunities for investors.

However, this investment super cycle is still a cycle and careful stock selection for the most durable opportunities trading at attractive long-term valuations is paramount in seeking long-term resilience.

Cyclical and industrial momentum

But it is the broader recovery of the ‘real’ economy that is providing the long-term foundation for small caps. We do not believe that US small caps have permanently shifted to being an asset class dominated by speculative growth opportunities, and we expect the reversion to more fundamentally driven factors – such as a focus on companies’ financial strength and operations – to continue.

Among the other sectors that have helped drive small cap returns recently is healthcare – in particular health care services and the biotechnology industry. Biotech has also seen significant momentum, driven by a broadening of positive investor sentiment and a spate of merger and acquisition activity within the sector.

Despite the headwinds from the Middle East conflict, the backdrop for the cyclical economy is becoming increasingly constructive. Secular growth themes tied to AI infrastructure, power generation, grid modernisation, electrification, and automation continue to dominate investor attention.

However, the more notable development is evidence of a broader improvement in the industrial economy beyond these specific themes.

Purchasing Managers’ Indices have shown solid expansion in US private sector activity, indicating a broader recovery across the economy. The debate has largely shifted from whether industrial demand is improving, to whether current guidance and consensus estimates fully reflect the magnitude of the recovery.

If the cyclical recovery remains durable, market segments with higher exposure to the so-called ‘real’ economy should disproportionately benefit. Smaller, domestically focused companies are likely to be the prime beneficiaries of US-centric trends such as reshoring and increased infrastructure spending.

Small caps offer potential

Even with the recent period of outperformance, small caps continue to trade at a historic valuation discount to large caps. Over the second quarter of 2026, US small caps had a price-to-earnings (P/E) ratio of 20.1, compared to large caps’ 28.3, according to Morningstar.³ A lower P/E ratio means a lower valuation in relation to earnings.

In addition, the structural composition of small-cap indices offers a level of sector diversification and cyclicality lacking in larger indices. Small caps tend to be less concentrated in terms of sector exposure or top holdings meaning returns are not dominated by a small group of very large companies.

This can also mean that small-cap equities typically receive less analyst coverage, creating more potential for investors to seek out hidden gems overlooked by the wider market.

Furthermore, small caps can often possess a level of flexibility and innovative spirit that allows them to respond to new opportunities or emerging challenges more rapidly than larger peers.

There is also the potential for these stocks to continue to gain traction should investors continue to shift their focus away from large-cap names in search of more attractive valuations and strong growth trajectories.

Through a combination of attractive valuations and exposure to both AI infrastructure and a broadening industrial recovery, we believe that US small caps currently offer an attractive potential opportunity for diversified growth.