Is it finally springtime for small caps? With significant developments in AI, healthcare, and financial services, recent market shifts suggest that small-cap earnings growth will outpace large caps this year, potentially marking the start of a new cycle of multi-year outperformance.
Small-cap stocks might find a turning point in 2025, according to Stacey Sears, Portfolio Manager at Emerald Advisers. As a key player in managing the Emerald Growth Fund (HSPGX) and the F/m Emerald Life Sciences Innovation ETF (LFSC), she has over two decades of experience navigating market cycles. From AI-driven industrial demand to biotech M&A and a resurging IPO market, several catalysts are positioning small caps for a breakout year.
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Springtime For Small Caps: Is The Long-Awaited Shift In Market Leadership Finally Emerging?
According to the Oxford Dictionary, springtime is “the early part or first stage of something.” Whether it applies to the seasonal re-emergence from the dark, cold winter months, budding new relationships, or a long-awaited cyclical rotation, it implies change, freshness, and revitalization. After a 14-year market leadership cycle for domestic large cap stocks (Figure 1), the second longest on record, the domestic equity markets are nearing an inflection point, potentially leading to a multi-year period of outperformance for small caps. In 2025, we believe earnings growth for small caps will approach, and likely exceed, that of large caps. The small cap market will be revitalized by a new generation of companies from a rebounding initial public offering (IPO) market. Merger & acquisition (M&A) activity will continue to rise with small caps being the most frequent targets and greatest beneficiaries. All this combined with near-historic small-cap valuations relative to large caps sets the stage for a potentially meaningful leadership change in the domestic equity markets – A Springtime for Small Caps!
A Change in Earnings Growth Leadership?
Earning growth drives stocks and it also drives market cycles. The period of large cap market leadership has been supported by relatively strong earnings growth for large caps. This dynamic is changing, and we appear to be setting up for a period of earnings growth outperformance for small caps. Small cap earnings growth appears to have troughed in mid-2024 and is now inflecting positively. (Figure 2) According to FactSet, the I/B/E/S sell-side consensus EPS growth estimate for the S&P 600 small cap index is 19.4% outpacing the S&P 500’s estimated growth rate of 13.2%, as of January 28, 2025. Furey Research Partners sees a wider gap emerging with earnings growth for the Russell 2000 estimated at 24.9% using their capitalized losses approach which attempts to adjust for the loss generating companies within the small cap universe. (Figure 3) The basis for small cap earnings growth leadership is a broadening economic expansion, rising capital spending behind Artificial Intelligence infrastructure buildouts, innovation driven opportunities in areas such as health care, software, and industrial technology, accessible capital markets, a solid employment backdrop, a healthy consumer, and relatively easy financial comparisons.
A Revitalized Market Driven by a New Wave of IPOs
The recovery in the IPO market is poised to continue in 2025, driven by a growing pipeline of IPO candidates, a broadening economic environment, and increasing investor appetite. According to Renaissance Capital, in 2024 total U.S. IPO proceeds grew 53% y/y to $29.6 billion on a 39% increase in deal volume to 150 IPOs but remained soft by historical standards. (Figure 4) In 2025, we believe that we will see a continuation of the IPO market recovery with IPO volumes likely approaching or exceeding the trailing 10-year average of 183 IPOs. This is supported by a steady rise in IPO filing activity, which increased 20% y/y in 2024 to 219 filings, marking the third consecutive annual increase and fourth highest total in the last decade. The pipeline is also broadening, encompassing innovative new public company candidates in a wide range of areas such as biotechnology, medical devices, software, consumer goods, financial services, industrials, and energy. A healthy IPO market has the potential to revitalize small caps, by introducing a new generation of companies with innovative product offerings and business models, presenting a new set of growth opportunities to investors.
Merger & Acquisition Activity on the Rise
According to the Institute for Mergers, Acquisitions & Alliances (IMAA), merger & acquisition (M&A) activity picked up modestly in 2024 with the number of deals in the U.S. rising 3% to 15,217 on a 17% increase in total dollar value to $1.69 trillion. (Figure 5) This marked the first increase since 2021 when M&A activity peaked at 25,170 deals totaling nearly $3.5 trillion. We see the potential for deal volume to rise further based on improved confidence in the economic outlook, expectations of a more favorable regulatory environment, relatively strong corporate balance sheets, meaningful benefits from scale in a wide range of industries, and attractive valuations in the small- and micro-cap portions of the market. Morgan Stanley Strategist Andrew Sheets is forecasting an approximately 50% rise in M&A activity in 2025, according to a November 2024 report. A rise in M&A activity is particularly positive for small cap stocks as approximately 90% of all public M&A transactions occur in the small- and micro-cap space, according to Furey Research Partners. Similarly, Steven DeSanctis, Equity Strategist for Jefferies, in a December 2024 report noted that 58% of all M&A transactions involve companies with valuations under $1.0 billion, currently the cheapest part of the (equity) market.
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