Thus far, 2026 has seen small-caps gain renewed market momentum and corresponding investor interest. After more than a decade of large-cap dominance, the conditions for a meaningful shift in market prominence are taking shape: the valuation discount of smaller companies relative to their large-cap counterparts has widened to its deepest level since the late 1990s, and forward earnings estimates increasingly favor the small and mid-cap space heading into 2026 and beyond.
For investors looking to identify opportunities amid an inconsistent market, we believe the potential is enticing.
However, while small caps are undoubtedly rallying and generating buzz, the most visible and discussed companies may not necessarily be the ones worth owning across multiple market cycles.
Historically, lower-quality, speculative names have led to the initial charge within small-cap rallies. There are ample examples of these “junk rallies” in recent memory, including the patterns that emerged following the Global Financial Crisis in 2008, the 2016 presidential election and the post-pandemic market. This dynamic is presently playing out yet again, now amplified by the excitement and speculation surrounding AI.
Investors seeking to replicate the success of the mega-cap technology rally have gravitated toward small-cap names associated with AI and forward-looking technologies. Recent rallies have been supported by network hardware and components, and next-generation energy supply businesses, as well as adjacent technologies like quantum computing. Despite the current enthusiasm surrounding these businesses, many early-stage, concept-driven or historically cyclical businesses presently generate little to no earnings, carry significant capital requirements or are priced at extreme valuations, implying several years of abnormally high growth. While valuations of these stocks have been generous for the time being, they may not necessarily hold up under scrutiny and the wear and tear of time. This “junk rally” dynamic has been a recurring feature of early small-cap cycles, and the stocks that have historically benefited most from them in the short term have tended to struggle in the long term without a sustainable improvement in their underlying fundamentals.
Although it can be difficult to separate the static from the substance amid a junk rally, we maintain that there are opportunities for discerning investors and wealth managers. While companies focused on AI and speculative technologies have dominated most headlines surrounding this small-cap rally, we see other businesses in the mix that may be less attention-grabbing but offer the potential for solid earnings growth, high returns on equity, conservative balance sheets, and durable competitive advantages. As they’re being overlooked in investor discourse, they are also being traded at valuations that we believe fail to reflect their underlying quality and potential for long-term success.
Before the current small-cap rebound, the outperformance of large-caps over the past decade was grounded in fundamental strengths. This includes strong earnings growth, robust balance sheets, and sustained waves of capital investments. While these conditions have rewarded hyperscalers and businesses orbiting in and around the AI space, the market’s overall health has become significantly correlated with the success of these companies. Large-caps have undoubtedly shown themselves to be able to generate returns across a prolonged period, but there is a great deal of risk in latching on to a passive large-cap index, where the top names represent nearly 40% of total weight, without any accompanying diversification of assets.
This concentration risk does not exist in the same form at the small-cap level. While the broader small-cap index carries its own quality concerns — a sizable portion of the Russell 2000 consists of companies operating at a loss — we believe appropriately applied active management can address these concerns. In our view, investors looking to capture the potential upside of the small-cap rally should not try to own the index, but rather, seek to identify the comparatively small number of businesses within the space that exhibit the kind of steady, compounding earnings power that generates durable value over time. Even as the total number of publicly listed U.S. companies has declined from roughly 7,000 in the mid-1990s to approximately 4,000 today, we take the view that there are enough entities of this scale operating today to construct concentrated, high-conviction portfolios without compromising on quality.
From our perspective, investors navigating the AI hype and small-cap rally need to focus on businesses that can demonstrate operational efficiencies, expand margins, and deliver more valuable products and services over time, rather than just attract significant partnerships and capital investments. When the dust settles, the companies that come to be regarded as solid investments tomorrow may not necessarily be the same businesses dominating market discourse today.
While separating the junk from the jewels brings its own set of risks and requires substantial time and energy, we maintain that past market cycles have shown the investment can be well worth the wait. Strategies in the small-cap space that prioritize quality have historically outperformed across full market cycles. What’s more, following periods of underperformance, they have been shown to make a stronger recovery than the benchmark, with that advantage compounding meaningfully over three- and five-year forward periods. For patient, disciplined investors willing to sift through the small-cap space and apply quality controls to potential stocks, we believe the current rally could offer attractive opportunities that may be beneficial in the future.
As we see it, investors seeking to make the most of the present small-cap rally need to closely scrutinize the sustainability of business fundamentals into the future and the current value the market is ascribing to them. While it can be tempting to go all in on the latest stocks heralded as “once-in-a-lifetime” investment opportunities, our experience has shown that it’s often the businesses that are quietly but consistently compounding and trading at reasonable prices relative to their earnings power that bolster the long-term financial goals of investors going forward.
