US small and mid-cap (SMID) companies have been out of favour since the pandemic due to the elevated interest-rate environment, heightened geopolitical tensions, recessionary concerns and the dominance of AI-related names, all of which have created an attractive valuation distortion. SMID stocks should trade at a premium due to their higher growth potential, but they are at a 30 per cent discount to large caps.
It isn’t so easy, however, to determine which companies to target: they tend to have significantly less research compared to larger corporations. But this information inefficiency presents an exciting opportunity for active managers to generate alpha by exploiting valuation dislocations through bottom-up research.
While valuation alone rarely triggers a rotation, the current macro, market and policy backdrop could provide the stimulus for a move into smaller caps.
Macroeconomic catalysts: Rate cuts and smaller caps
While progress on interest rates stalled in early 2025 due to persistent inflationary pressures and cautious policymaking, the Federal Reserve has now resumed cutting interest rates.
This shift is particularly supportive for smaller companies which tend to outperform in environments where monetary policy is loosening. In the eight rate-cutting cycles since 1979, small caps have outperformed large caps by an average of 6 per cent in the 12 months following the first cut.
The present policy divergence between the Fed and the European Central Bank (ECB) adds a layer of relative attractiveness. While the Fed retains flexibility to ease further, the ECB has signalled that it is approaching the end of its rate-cutting cycle. We do not expect interest rates to return to the ultra-low levels that characterised the post-Global Financial Crisis and early in the pandemic. In this environment, companies with strong balance sheets, pricing power and consistent cash-flow generation are better positioned to navigate elevated financing costs and macro volatility.
Market catalysts: Earnings momentum is accelerating
Consensus earnings growth expectations for the SMID class now exceed those of large caps and the Magnificent Seven cohort of mega-cap tech stocks – marking a potential inflection point in market leadership. While these behemoths have driven much of the recent stock market performance through multiple expansions and the AI-driven narrative, their earnings growth is expected to normalise. In contrast, SMID caps – with their higher domestic focus and leverage to a cyclical recovery – are poised to deliver stronger bottom-line growth.
The superior earnings growth potential of SMID stocks could help to close the relative performance gap; coupled with the valuation distortion and dovish market expectations, this could provide an attractive entry point for SMID investors. Alongside improving earnings momentum, the policy backdrop is also turning increasingly favourable for these companies.
Policy catalysts: A pro-SMID policy agenda
The return of President Donald Trump to the White House has reignited focus on domestic growth, deregulation and industrial revitalisation – all inherently supportive of SMID companies, the backbone of the US economy. Following Trump’s re-election in November 2024, SMID caps rallied 7.2 per cent, outperforming large caps and reflecting investor optimism around pro-growth policies.
The “America First” agenda prioritises domestic production, creating a uniquely supportive environment for SMID companies, which are significantly more domestically focused than large-cap companies. This specifically benefits SMID-dominated sectors like industrials and materials.
Secretary of the Treasury Scott Bessent’s 3-3-3 plan, which aligns with the One Big Beautiful Bill Act, is poised to boost US economic performance and should disproportionately benefit SMID companies. The act is particularly constructive due to tax deductions and regulatory relief. These companies pay closer to full corporate tax rates relative to their larger-cap peers, so any reduction would directly boost after tax earnings and free up capital for reinvestment. Additionally, regulatory easing would reduce compliance burdens that SMID companies often struggle to absorb. This potentially could enhance operational flexibility, improve margins and unlock growth potential.
In parallel, the backdrop of falling interest rates and attractive valuations sets the stage for a pick-up in mergers and acquisitions activity. This adds optionality and upside for investors, as consolidation can accelerate growth and drive shareholder value.
The evolution of AI
The transformative power of AI is not confined to the tech giants. Across the SMID landscape, a growing cohort of companies is harnessing AI to drive innovation, unlock operational efficiencies and create new market opportunities. For investors, this presents a compelling chance to gain exposure to the evolution of the AI ecosystem – often at more attractive valuations, with greater upside potential and, importantly, offering diversification.
SMID firms play a critical role in enabling the infrastructure behind AI. From fiber optic components and cooling systems for data centres to precision tools for semiconductor manufacturing and testing, they help to power AI’s rapid expansion. Also, many SMID companies are leveraging AI internally to enhance efficiency, reduce costs and improve service delivery. In other words, AI serves not just as a technology upgrade but as a strategic enabler of productivity and scale. SMID companies’ dual role here as enablers and beneficiaries of AI puts them in a strong position in the value chain, offering investors another way to catch the AI tailwind.
