This under-appreciated segment of the market could quietly gain momentum in the year ahead.
00:00:00 – Introduction
00:00:25 – Why Small Caps Now?
00:01:51 – Large Caps vs. Small Caps Outlook
00:04:43 – Market Impact if Small Caps Lead
00:06:16 – Small-Cap Value Opportunities
00:07:41 – Positioning for 2026
00:09:49 – Are We in an AI Bubble?
Transcript: Caroline Woods:
Joining me now, Brett Meyer, head of capital formation at Towle & Co. Brett, great to have you on. Thanks so much for joining us.
Brett Meyer:
Pleasure to be here. Excited to chat with you.
Caroline Woods:
Yes. And we’re chatting about small caps. Large caps have been dominating certainly this year but for more than a decade. But why is now the time for investors to pay attention to small caps? Fill us in.
Brett Meyer:
Yeah, it’s a great question. And you’re right, it’s been almost basically two plus decades of pretty substantial outperformance by large caps relative to small caps. Listen, I’ll give you two scenarios where we really think that small caps, and particularly small cap value where we focus at Towle & Co., could really outperform going forward. The first one I’ll give you is a bullish scenario for the economy overall.
Look, there’s incredible positive tailwinds from the adoption of artificial intelligence that are starting to come through the economy. And we think that particularly for smaller cap companies that tend to have lower profit margins, that could be a stealthy tailwind to their margins on a go-forward basis. And then a lot of people are not focusing yet on that one big, beautiful bill, but that could be upwards of a 1 to 1.5% tailwind to GDP next year.
And so overall, we see tremendous earnings growth going into next year. Our portfolio—if we use Capital IQ and look at the weighted average earnings per share growth estimate for next year—is actually 30%, which is notably above any large cap benchmarks. So that’s a scenario where small cap and small cap value could really start to outperform going into next year.
The other scenario that I’m sure is on everyone’s mind is some kind of a rewind of the 2000 dot-com bubble unwinding. The AI trade has been remarkable, and a lot of these businesses are quite incredible. Some of the large cap mega-cap names have tremendous profit margins, but there are many signs pointing to the fact that on a relative basis, we’re more stretched in valuation between large cap growth and small cap value than we were in 2000.
Trying to figure out a catalyst for when that unwind might happen is really difficult. With hindsight, I’m sure it will become obvious. But if there is a trade away from the large cap mega-cap stocks, as that starts to move, that capital comes out of the market and will look for cheap stocks elsewhere.
2000 to 2007 was a golden era for small cap value investing, and Towle had its best five- to seven-year run. So we see that potential as a possibility as well. Those are the two scenarios where we could see small caps and small cap value start to outperform.
Caroline Woods:
I’m curious what your outlook for large cap stocks is. Do you see a world where small caps outperform without hurting the big names, or does it come at their expense?
Brett Meyer:
That’s a really good question. In the first scenario I mentioned—the bullish one—I do think small caps outperform large caps, but maybe not by as dramatic an amount. Maybe small caps go up twice as much as large caps, double the S&P 500.
In comparison to the bubble burst back then, you can’t even calculate a percentage difference because the S&P was down from peak to trough 50 or 60%, and small caps ended up being up 50 to 70% during that same time period. So there are two scenarios: one where it’s a more muted differential, and another where if there is truly a move away from the AI stocks and large caps, you could see small caps dramatically outperform and generate absolute returns while many large caps have negative performance for a period of time.
Caroline Woods:
So then my follow-up to that is: If small caps start to lead the market, what does that mean for the direction of the overall market? Because mega-cap tech names have really powered the market higher.
Brett Meyer:
I think if small caps lead next year, that’s a strong sign for the overall market. I suspect large caps will come along for some of the ride as well. That’s probably the most bullish scenario—small caps continue their leadership. But here’s an interesting point: If you look at the largest weightings in the Russell 2000, many of them are AI-derivative plays. There are nuclear small reactor companies, quantum computing stocks, and drone companies.
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