Small-cap stocks will be in a 'sweet spot' for quite some time: Royce Investments' Francis Gannon

Summary

Francis Gannon of Royce Investments argues that small-cap stocks are in a multi-year sweet spot driven by a powerful earnings recovery, AI tailwinds, reshoring, deregulation, and tax incentives. He notes the outperformance is already 16 months old and historically such cycles can last a decade after long large-cap dominance. Despite the strong run, ETF flows remain negative, indicating that disbelief is still high and further upside likely. He recommends active stock picking to capture the opportunity while managing the inherent higher volatility of the asset class.

• Small-cap earnings turned positive at the end of last year after two years of negative growth and are expected to surpass large-cap earnings by end 2025/2027.
• Five key drivers: Fed easing, AI demand (both productivity and physical goods), reshoring, deregulation, and 100% depreciation on capex/R&D.
• Outperformance is not a head fake; it began in April 2024 and is already 16 months old, with more room to run according to historical decade-long cycles.
• While large caps dominated the last ten years, small caps tend to outperform for a decade once they begin to lead; Gannon believes we are at that inflection.
• Small caps are under-owned and net ETF flows remain negative, suggesting the market is still in 'show me' mode and the upside is not fully priced.
• Higher volatility (typical annual drawdown around 19%) is the price of an average annual return near 11%; investors should use volatility to build positions.
• Active stock picking can help identify quality businesses in small caps and manage the risk, though no specific funds or tickers were named.