Small caps deserve a closer look

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Host/John Przygocki: Welcome to Talking Markets with Franklin Templeton. I'm your host John Przygocki from the global marketing organization at Franklin Templeton. Today I'm joined in the studio by Chris Galipeau, senior strategist with the Franklin Templeton Institute, and Frank Gannon, chief investment officer at Royce Investment Partners.

The Institute is a research-centric organization here at Franklin Templeton focused on delivering unique macroeconomic and capital markets insight to our clients. Royce Investment Partners is the small cap specialist at Franklin Templeton with unparalleled knowledge and experience, true pioneers with more than 50 years of investment success. Gentlemen, welcome to the show.

Chris Galipeau: Thanks, John. Thanks for having us.

Frank Gannon: Yeah. Thanks, John. Appreciate it.

John Przygocki: I've really been looking forward to our conversation focused on the small cap asset class. Capital markets have been quite active given all of the geopolitical and macro-economic activity across the landscape. Chris, let's start with you. Can you set the stage for our listeners by touching on the current macro environment relative to US equities?

Chris Galipeau: Yeah. Happy too, John. You're right. There's been a lot that's happened here in the first four months of the year and now entering May. Look, I think when we think about the macro backdrop in the US, I would say this that the economy remains resilient. And to me there's really three legs to that stool, one being the CapEx spend by big tech and by other industries, frankly, which continues unabated. We get more data points this week from the likes of Google and Apple and Amazon that spoke to that. And that's a multiyear thing, John. That's not something that's going to be a quarter or two. That's going to be years in process. So that continues on.

The second leg is the consumer in the US, which drives two thirds of GDP. And what we've heard there from companies as they report earnings, is a very consistent picture that lays out the resilience of the US consumer. And I think one of the best ways for all of us to get our finger on the pulse of the consumer is to listen to what we hear from the big banks when they report earnings. So, the likes of JP Morgan, Bank of America, Citibank, Wells Fargo, et cetera, even the regional banks have been very consistent in their messaging right through 2025, right through the first quarter of this year.

And talking about the resiliency of the consumer, a few of the banks even talked about consumer spending patterns in Q1. And it ranged, but it was generally in the range of 5 or 6%, meaning that consumer spending was up 5 to 6% in Q1 of 2026 versus Q1 of 2025. So, despite some of the geopolitical events and concerns (mostly what I'm talking about there is higher gas prices) really hasn't had an impact on consumer spending.

And, you know, we got some more data points last week on that from some consumer-centric companies. So, in no particular order here, we heard that message from Starbucks, Pepsi, Coke, General Motors. And it was even further reinforced in comments from Visa, Mastercard, Capital One. So, barring anything that would cause a significant jump in the unemployment rate here, the economy in the US is resilient. The consumer in the US is resilient. And I think those two legs are of primary importance to continue that.

And then the third leg would be a combination, I guess, of the tax refund status here from the One Big Beautiful Bill, which has certainly served to offset maybe some of the rise in gas prices. But tax returns are trending somewhere around 15% up versus last year, and the aggregate amount is somewhere between $100 and $150 billion more being refunded to taxpayers this year versus last year.

So I think you've got those three major legs of the stool in the mix: CapEx spending, a resilient consumer amplified by tax refunds. And there's a chance albeit, I guess, a small chance—there's a chance we could get maybe a rate cut in the back half of the year here. But so far, so good despite the noise, which honestly is very confusing to a lot of investors right now, which we can get to in a minute.

John Przygocki: So, sounds like economically here, although we face some headwinds, we are on solid footing. Now, you're at the center of Franklin Templeton. Coming into the year, I believe you were pretty positive on the small cap space. Has anything changed?

Chris Galipeau: Nothing's changed. The reality on the ground is this, John, that earnings estimates for every major index in the United States (large cap, small cap, growth and value) increased from January 1 right through to the end of April. So not only has the story not changed, I'd argue that the story looks better and that earnings in Q1 at the S&P [500 Index] level are up about 15% year on year, and that's ahead of where we started the year.

It's above our own internal expectations. The same is true, for example, in small cap space and mid cap space. And so, the earnings picture has been very robust. And I would just remind our listeners that what drives the stock market, any stock market, any index, any part of the world, any individual company is the company's forward earnings power. And that has been improving, not deteriorating year to date.

John Przygocki: So, the earnings picture across the spectrum has been improving. When we look back at the first four months of the year index performance, if we were to compare the Russell 2000 (typically the proxy for the small cap space) versus the larger market S&P 500, anything to highlight?

Chris Galipeau: Yeah. Fortunately for us, with our bullish stance on small cap space, the S&P is up just under 6% here year to date. Russell 2000 is up 13.32. That's down middle of the fairway, Russell 2000 at the index level. Small cap growth. So, Russell 2000 Growth is up about 12%. And small cap value, Russell 2000 Value, is up just over 15%.

Those are the three lead indices in the United States here year to date. And that's exactly what we were hoping to see. And that is also where the most robust earnings growth is in the US by size, by style. It's the sweet spot.

John Przygocki: Okay. Frank, let me turn to you. As a firm, we've been talking quite a bit about performance in equities really broadening out beyond the mega-cap tech firms. Thinking about what Chris has just laid out there, as the chief investment officer and a portfolio manager at Royce, where do you see the current opportunity in the small cap asset class space?

Frank Gannon: Thanks, John. And thanks, Chris, for kind of setting me up here a little bit. But when I view the small cap asset class today, I think of it as: we are at the beginning of what is going to be a multi-year period of outperformance. Typically, when small caps start to outperform, as Chris has highlighted, they do so for more than a decade if you go back in time and look at the outperformance cycle of small versus large.

So, we are what we believe to be just at the very beginning of that, powered by, you know, as you mentioned, the broadening of the overall market, but the broadening of the overall market from my perspective, is not just a broadening from the equity standpoint, but also from an earnings perspective.

As Chris alluded to, we are going to see I think the earnings story continue to be quite powerful for small caps. So, beneath the surface of the market today, the market is changing. And I think that's what investors have to focus on. It's changing from this idea of concentration in the upper end of the market to really much broader participation. And from my perspective, I think that's really exciting.

John Przygocki: So, Frank, are you saying that small cap stocks are positioned right now to take that leadership position forward?

Frank Gannon: The simple answer is yes. But the reality is that they already have. The Russell 2000 is outperforming not just the S&P 500 and the Nasdaq on a year-to-date basis, but also for the full year period ending, the end of April here.

So it's already happened. Small caps have outperformed over the past year. And I don't think people have really focused on that. It's still, as I like to call it, the “forgotten asset class.” It's the asset class that people haven't really focused a lot on, and yet it's full of opportunity. And I think the real answer to your question is they already are in a leadership position, and it just hasn't been picked up on yet.

John Przygocki: So it hasn't been picked up. Leadership position has been established. We talked a little bit about earnings season and how it's gone so well to this point. What have you seen in the asset class?

Frank Gannon: So, first quarter earnings, small cap earnings tend to come a little bit later. So, we're still pretty early in the process for small cap companies to be reporting. I'd say about 25% of the index as reported so far. But that being said, if you go back a couple of years, in 2023 and 2024 small cap earnings were actually negative. And now they've turned positive at the end of 2025.

And we think they're going to continue to not only be positive, but actually be ahead of large cap earnings for 2026 and going into 2027. And there's a lot of trends behind that that I think—Chris alluded to some of them—but I think that are going to continue to drive this broadening story from an earnings perspective that small cap companies are really going to benefit from.

John Przygocki: Chris, you spent time just this week with financial advisors. Any observations relative to the small cap asset class?

Chris Galipeau: Absolutely. First thing I would do is emphasize what Frank just said. We've been in a rotational bull market for almost two years, and that's largely gone unrecognized. We've been standing, you know, on the podium and pounding about it. But we first saw this start specifically in small cap space in July and August of ’24. And I've learned over my career that when something starts to move and you might not either A) expect it or B) necessarily understand it, it's time to do some work on that. So we did exactly that, and we were trying to figure out what the market was sniffing out. And as Frank correctly points out, it was the market's realization that we had reached probably the low point in earnings degradation in small cap space. And that was shifting.

And as we did the analysis, what we saw was forward cumulative earnings growth for small cap space was about to explode entering 2025. And so, we established our bullish call coming into ’25, specifically in January. That earnings picture has only gotten better on a go-forward basis. Now, with regard to us sharing that information with our clients across the country, generally, as I've walked them through the bull case for small cap space (and Frank's right on this) that this is the spot in the US where EPS growth is the strongest. That was true in ’25. It's true in ’26.

Now, in conversation, I would say that the vast majority of investors are underweight small cap space relative to what they might have in a policy portfolio or a neutral allocation. And they're underweight for, I think, the reasons Frank hit on, where you went through a couple of years of what we call an earnings recession, sequential decline in earnings, and either they're a little bit gun shy or they fail to recognize that the pendulum has swung in the other direction. And we know that stock prices follow earnings. And, in reality, stock prices lead earnings.

And that's what the market was telling us in ’24 and into ’25. That's continued on. So, they're skeptical. They're definitely underweight. And some investors are substantially underweight, meaning no exposure or de minimis exposure. And I guess I feel like, as hard as we've tried to push on this, there are a lot of nonbelievers there. And, you know, sometimes it's difficult to change your perspective.

But when you're confronted with the empirical evidence that we show our clients every day that that is where the earnings power is coming from in the next couple of years, it demands you pay attention and, frankly, you should be increasing exposure there, which has been our stance for the last year and a half there.

Frank Gannon: Investors are thinking what they've seen is just a head fake, right? They’re waiting for something bad to happen from a small cap perspective. And maybe we've seen that a little bit in some of the volatility earlier this year. But to your point, you know, that famous kind of investor saying is, psychology might run the market in the short term, but earnings runs the market in the longer term.

And going from that negative moment to positive moment and continuing on that positive road from an earnings perspective for the small cap asset class is one that I think is pretty powerful and, you know, not well known. And I think that's going to make the asset class even more attractive. And throw the valuation story in there: you’re valuing these companies at what could be depressed earnings.

John Przygocki: So, with the run up in big tech mega-cap and the percentage that these companies have in the major indices, there's concern at an investor portfolio level around concentration and concentration risk. Does that particular element make an allocation to smaller companies more compelling today?

Chris Galipeau: I'll take the first cut at that, I guess. We think so. As we entered calendar year 2025, we had already seen the initial burst of small cap out of the gates in the summer to fall of ’24 that had our attention. We did the research on what was going on under the surface. As Frank just pointed out, the earnings picture was getting better.

But what we also found through further primary research was that there are conditions in place historically that precede a quote unquote, broadening of the tape. And those conditions, there were four of them that we identified that were that were present before every significant broadening in equities in history. And those four variables were improving GDP, the Fed cutting rates, improving earnings estimates, and the fourth one, John, periods of high index concentration.

So, all of that was in place as we were entering 2025. And, of course, we talked about that, wrote a paper about it and published it then. But I go back to what Frank talked about and what I think we both believe is, is this: that stocks follow earnings over time and the strongest earnings power, the most compelling earnings stories have been and continue to be in small cap space.

Now nothing wrong with the Mag Seven, right? There's nothing wrong with large cap growth. Those companies are fine. They’re world class. But that is where everybody is allocated. And it kind of ties into what we talked about earlier, where most investors are very overweight that part of the tape, probably because of the performance there from, let's say, 2020 to the first part of 2025. And that's where all the earnings power has been.

So it's a perfect, perfect rationale for it. And also another data point: that stocks follow earnings over time. Now the puck's going to a different area. Mag Seven’s fine. But you have to pay attention to what's going on in small cap space. And that's really what we've been focused on with the notion and the complete conviction and belief: stocks follow earnings over time.

It's happening. It's happening. And Frank referenced year-on-year comparison through April. If you go back to January 1 of ’25 through Friday’s close, last Friday's close anyway, the best performing index in the US is the Russell 2000.

Frank Gannon: The only thing, John, I would add to that is the fact that, you know, we know that relative valuations for small cap versus large cap are still below average. And I think that, in a world where so many people believe that innovation can only be found in the upper end of the market, I would just highlight there's an enormous amount of innovation taking place in the small cap asset class within technology companies, within industrial companies, within materials businesses that are going to be clear beneficiaries of some of the trends we're seeing from an AI perspective.

And so, you know, I think of the market as being so focused on the AI kind of trade, if you will, but there are companies that are going to be the beneficiaries of that in a lot of different ways—not just from a productivity standpoint, but also as a supplier to that world as well. And a lot of them happen to be small cap companies with great valuations that are just not recognized yet within the market.

John Przygocki: So, Frank, the importance of active management in the small cap space. Your perspective there?

Frank Gannon: I think of small caps as the last inefficient asset class. In a world where large caps have done so well for a period of time, you know, there are not a lot of firms doing research on the small cap asset class. So it takes a lot of heavy lifting to kind of do the research and understand a lot of these businesses.

But that also represents great opportunities, right? The Russell 2000, at the end of the first quarter of this year, over 41% of the of the index was comprised of non-earning companies. So if you can spend your time to understand the businesses that actually make money, that actually have earnings, that actually have great cash flow and valuation, I think you can build a really exciting portfolio that you can own for a long period of time. And that's effectively what we try to do here at Royce and have been for a long period of time.

John Przygocki: So, Chris, when you think about the investor and the risk that they may run in being underweight small cap, are their implications over a long period of time at the portfolio level?

Chris Galipeau: Yeah, I think that there's a couple, John. Frank just answered that when he talked about under-the-radar companies that will benefit from the AI spend that's typically attributed to large cap space, and they get all the airtime and all the commentary. So I think that's a great point.

And it's not just in one industry. It spans multiple industries, multiple sectors. And, so, by not having exposure there you limit yourself. But I think, moreover, to me when I think about that, I go back to if you believe (and we do, I do, Frank does) that stock prices follow earnings over time, by running naked small cap or very underweight small cap you're not doing the portfolio justice by recognizing that there is strong earnings power to be had there.

And as Frank said earlier, when small caps move, they move, John. And it's not just a flash in the pan thing that people might be  worried about. If we thought it was a flash in the pan, we wouldn't have been pounding on this for almost two years. And, so, I think by not having exposure there, you don't avail yourself to having exposure to explosive stories, to good relative valuations (Frank points out), and absolute EPS power going forward. I think investors need to think about that, right? You need to have some exposure here.

John Przygocki: So, Frank, for an investor who is considering an allocation in the small cap space, entering into it, are there catalysts that that you might highlight?

Frank Gannon: I think the largest one is the earnings story that we've been talking about. And I think if you look at some of the secular tailwinds that can really affect the earnings story for a lot of small cap companies, we've talked about an easing cycle. Chris kind of mentioned that. You know, 40% of the debt in small cap companies happens to be variable rate. So, when rates come down, that's a positive for small caps.

You have this new, you know, tax policy, if you will, from the One Big Beautiful Act that was signed into law that talks about 100% depreciation on CapEx and research. I think the CapEx cycle here is going to be powerful, a clear beneficiary to a lot of small cap companies.

The reshoring trend, which has been talked about for a couple of years now, you know, that's going to create really sustained demand for a lot of domestic suppliers and service providers. Again, small cap companies have a kind of a strong market share in that particular area. We spoke briefly about AI. AI adoption is raising productivity in smaller companies. So you're going to see that kind of flow through to the bottom line from an earnings perspective, from an operating leverage perspective and maybe even margin expansion for a lot of these businesses.

And then, finally, I’ll just highlight deregulation. Deregulation disproportionately benefits small cap companies. And so I think those are just some of the areas from an earnings perspective, you know, these secular tailwinds that we think will go on for a while.

The other thing I would just say is the volatility story that has been relatively present this year. We had an 11% correction in the Russell in the first quarter of this year. Large intra-year declines within the asset class are very frequent. If you go back throughout the history of the Russell, even go back to the year 2000, what you see is the average intra-year decline for the Russell 2000 is about 19.6%, but the average calendar return is 10.2%.

So, use the volatility that the market is giving us over the next several months around war, around whatever we might be focusing on from a short-term perspective, as an opportunity to build a position in the asset class over the next several years, I think.

By the way, higher volatility is really good for active management, and that's being able to use that volatility. When a market’s down 11% like we saw in the first quarter, there's a lot of companies down a lot more than 11%. The average stock in the Russell 2000 was down close to 29% in the first quarter. So, we're able to take advantage of that. That's our ability to kind of buy future performance, if you will, at great prices.

Chris Galipeau: I think that's a great point. I try and remind our clients that when stock prices are coming down and vol is high, that's also creating the opportunity, as you just alluded to, Frank, and that volatility favors the prepared investor. And another concept that I think people lose because they can get emotional in drawdowns is that you have to remember that when stock prices are coming down, so is the risk in owning them. Assuming you've done your fundamental work and you know the story and you're comfortable with it, the stock probably just got cheaper.

Hey Frank, I have a question for you that I get a lot out in the field with our clients. And I'll paraphrase the question, but it goes something like this. “There aren't a lot of high-quality small cap companies,” or “there aren't a lot of smaller companies coming public because private equity is gobbling those companies up before they come public” and/or “companies just don't want to come public.” I think you have some thoughts on that, and I'd love to hear your answer to that question.

Frank Gannon: It is the biggest question we get, you know, just the size of the small cap asset class in terms of number of companies, right? If you go back and you look at the size of public companies and things like that, there are more public companies today than there were coming out of the financial crisis in ’08 and ’09.

And I think of small caps as being kind of this evergreen asset class, if you will, where companies are coming public, where they're being spun out of larger businesses, where they're being acquired, et cetera. So I view that as kind of the opportunity for small caps. Most of or the majority of companies are still IPOing as small cap companies. You just don't happen to hear about them, right? You're just not reading about them like we're going to hear a lot about the three big IPOs that are going to be coming this year, that people are already starting to talk about.

The other thing about the quality aspect of the of the index is that “small caps are lower quality in general.” Well, we talked a little bit about the fact that 41% of the index is loss- making companies, but that means that there's a lot of companies that actually are earning companies. In fact, more companies earn in the Russell 2000 than in the Russell 1000. So there's a lot of companies that are great from an investment standpoint, from a fundamental, from an earnings perspective.

And then lastly, I would highlight a trend that we've noticed over the past year and a half now. And we know that the private equity world has an exit problem at the moment. So they're looking to IPO businesses, which is great. But also, they have a dividend problem. And I think that one of the trends that we're pretty excited about is that our higher-quality small cap companies, those with great balance sheets that don't technically need access to the capital markets to continue to grow their business, are actually buying businesses from private equity.

So, how strange is it that small cap, high quality, small cap companies are actually providing liquidity to the private equity world? Again, something you're not hearing a lot about, but it's a trend that has continued so far this year and we think is going to continue, that good businesses in any market environment, in any economic environment, if they have the strength of balance sheet and cash flow, can actually continue to grow their business to become a better business.

And small cap companies now are being able to do that from actually purchasing companies from the private equity space at, by the way, I would say, pretty significant discounts to where the private equity world has marked those businesses. So, we view it as an opportunity.

John Przygocki: So gentlemen, we are coming to the close of today's conversation. Can you just share a final thought for our listeners?

Chris Galipeau: John, what I would say is what we've been saying basically since the latter part of ’24, which is have your portfolio exposed to companies with strong forward earnings growth. And, so, to us that has meant, come down in the cap stack. Make sure you have some exposure in small cap space. We know, because we see the data and talk to our clients about where they're allocated, we know that they're very top heavy, specifically Russell 1000 growth. And that's been the spot to be in the last five years, no question.

But markets do change, and the puck will always go to where the forward earnings power is. It's in the small cap space. And, so, our advice would be to, number one, recognize that. Number two, take action. Get some exposure there. And even if you find yourself underweight, sometimes the hardest thing when you're managing money can be to recognize you need some exposure in a different area.

But investors will always think to themselves, oh, if I buy it here, I'm going to top ticket, right? So I get this question a lot. I know how they feel. Frank knows how they feel. That's not likely to happen here, knock on wood, without guaranteeing anything. But one of the ways that you can address the anxiety of being underweight something is to start the position.

So, go ahead and put the trade on the blotter. Get 50 basis points or 100 basis points established in accounts, and then be prepared to add to that on any sort of drawdown, any, you know, higher vol period, risk-off period, as Frank alluded to. Undoubtedly, we'll get some more of that here as we go through the year, and use that weakness to build the position up so it's meaningful. So it will impact the portfolio. And have confidence in that. And that that would be my advice here going forward, John.

John Przygocki: Thanks, Chris. Frank?

Frank Gannon: There's not much really for me to add. I would just highlight the fact that for, you know, investors willing to look beyond the largest names in the market today, the environment for the smaller names is becoming increasingly favorable. And small caps, in particular, appear really well positioned, given their combination of attractive valuations, relative valuations, improving earnings prospects and historically low expectations. And just to kind of reiterate that last point Chris made, continue to use volatility as a way to position or increase or build a position in an asset class that we think is at the cusp of what could be a substantially long outperformance period.

John Przygocki: Gentlemen, thank you for your time and wonderful insight today. To all of our listeners, thank you for spending your valuable time with us for today's conversation on the small cap asset class. If you're interested in learning more from Franklin Templeton, visit Franklin Templeton. If you'd like to hear more Talking Markets with Franklin Templeton, please visit our archive of previous episodes and subscribe on Apple, Google or Spotify.