How have small-caps been performing recently?

Chris Clark: We were very pleased with performance for the small- and micro-cap indexes. In the second quarter, the Russell 2000 Index rose 21.5%, and the Russell Microcap Index gained 25.6%, versus respective gains of 15.1% and 10.7% for the large-cap Russell 1000 Index and mega-cap Russell Top 50 Index.

We were even more pleased with the long-term results for our flagship, Royce Small-Cap Fund, which beat the Russell 2000 Index (its small-cap benchmark) for the year-to-date period ended 6/30/26 as well as for the 5-, 10-, 20-, 30-, 40-, and 50-year periods as of 06/30/26.

Francis Gannon: Longer-term results for the small- and micro-cap asset classes were also strong on both an absolute and relative basis for small- and micro-cap stocks. For the year-to-date period ended 6/30/26, the Russell 2000 advanced 22.6%, while the Russell Microcap increased 27.5%, compared to respective gains of 10.3% and 2.0% for the Russell 1000 and Russell Top 50. For the 1-year period ended 6/30/26, the Russell 2000 was up 40.8%, the Russell Microcap gained 58.5%, the Russell 1000 was up 22.0%, and the Russell Top 50 returned 16.3%.

Small- and Micro-Cap Are Leading the Market in 2026
Russell Index Performance, 12/31/25-6/30/26

Past performance is no guarantee of future results.

How was performance off the April 2025 market low?

FG: If anything, the results were even more impressive: from 4/8/25 through 6/30/26, the Russell 2000 rose 74.5%, which is terrific—and the Russell Microcap increased 108.4%! Over this same period, the Russell 1000 and Russell Top 50 were up 52.8% and 49.0%, respectively. Over this same period, the Nasdaq Composite was up 73.1%. So, it’s been a vibrant cycle across the board, but especially for small- and micro-cap stocks.

What do you make of the idea that small-caps do best when rates are low or falling?

CC: We should delineate rates and spreads because I think there might be a greater sensitivity to widening credit spreads as opposed to the absolute rate. The rate of change tends to be what spooks investors more than the rate itself. It’s also important to keep in mind that high yield spreads are historically narrow right now—at around 283 basis points compared to a long-term average of around 500 basis points. This means that investors are asking for relatively little compensation to take on the risks of default or limited liquidity, while markets are also pricing in a positive macro environment. Together, this is making high-yielding bonds relatively inexpensive compared to their long-term history. So, while rates have gone up, we’ve seen no indication of credit deterioration or concerns about credit within small-cap.

Miles Lewis: Small-cap returns and changes in rates are also not as closely correlated as many people assume. There are other important conditions that have historically been more impactful than changes in rates, such as valuations, earnings trends, and the state of the economy. So while it’s generally the case that a shift in interest rates affects smaller companies more than larger ones, there’s a lot of context that needs to be accounted for before assuming that a cut will help, or an increase will hurt.

What factors do you think can support ongoing small-cap leadership?

FG: I think it’s mostly the same story we’ve been telling—it’s all about earnings, specifically that small-cap earnings have been gaining strength over the last year. They’ve been steadily narrowing the gap with large-caps to the point that earnings growth is projected to run at a higher rate for small-caps through the rest of this year and into 2027. A lot of that growth is coming from CapEx spending tied to the AI buildout for both small-cap suppliers into that supply chain as well as for companies that have been able to improve efficiency and profitability by using AI. Companies that make semiconductors and related equipment, for example, have enjoyed significant growth so far this year, and in some cases going back to 2025. It’s no surprise that the Information Technology sector made the biggest contribution to small-cap performance for both 2Q26 and the first six months of the year.

What other sectors, industries and/or factors have been driving small-cap performance for the year-to-date period ended 6/30/26?

CC: Beyond tech, the top contributing sectors were Industrials, Health Care, Financials, and Energy, although Energy detracted in the second quarter due to the war with Iran. Several industries made meaningful contributions. Small-cap banks saw positive results, for example, as did electrical equipment manufacturers, construction & engineering companies, and biotechnology.

FG: I think it’s also likely that cost-cutting and greater operational efficiencies beyond what AI has facilitated have also helped, as did the rate reductions in the second half of 2025. Many small-cap companies carry floating rate debt, so lower rates may have boosted profitability on the margins for certain businesses.

ML: What’s interesting to me is the question of why the market has been rewarding lower quality. Although a lot of profitable companies have been participating in the rally since April of 2025, many of the companies that are benefiting from the AI euphoria have no revenue and no earnings, but that hasn’t stopped them from fully participating in the AI infrastructure build out. Most are companies that our Quality Value process would have never taken us to. I do think this will start to shift at some point in the coming months.

Are you concerned about a bubble in stocks connected to AI?

ML: I think it’s a legitimate concern. I also think some of the air has to come out of the AI balloon for other areas of the market to benefit. In fact, we’ve seen an interesting dynamic at play on certain days when a broader swath of small-caps does well while the NASDAQ—a tech-laden index—falls anywhere from 1-3%. That’s a familiar pattern from previous bubbles. It’s also what we’d expect when there is a transition in leadership. It’s almost never a clean break but usually looks like a game of tug of war. It’s also notable that in 2000-2001, the NASDAQ had a few rallies in the 15-20% range on its way to being down -78%. There are other similarities to the Internet days. AI is going to be transformative just as the web has been. There will be new industries created, and businesses that don’t exist today will be household names in 10 years, but there’s a lot of hype and a fair amount of malinvestment going on, which raises the possibility of a bubble.

CC: I think don’t think the “Big 3” hyperscalers, Amazon, Google, and Microsoft, are at risk of a bubble. Their valuations are not cheap, but they’re also not irrationally expensive. It's not like the days of the tech bubble where companies were trading at 80 times earnings or where companies with significantly large market caps had no earnings or revenues.

There has been a lot of commentary about valuations in the U.S. market being unsustainably high. Do you think that’s an accurate assessment of small- and micro-cap valuations?

Andrew Palen: I think the research we’ve done here at Royce shows that small- and micro-cap valuations are not nearly as high as those of large-cap stocks. We like to measure index valuations using EV/EBIT, or enterprise value over earnings before interest & taxes. The chart below shows that valuations for small-cap versus large-cap, even after more than a year of robust returns, were still close to their lowest levels versus the Russell 1000 in 25 years at the end of June.

Relative Valuations for Small-Caps vs. Large-Caps Remain Near Their Lowest in 25 Years
Russell 2000 vs. Russell 1000 Median LTM EV/EBIT (ex. Negative EBIT Companies), 6/30/01 through 6/30/26

Source: FactSet

Micro-caps, which is where I do most of my investment work, have performed even better than small-caps over the last year. When we applied the same EV/EBIT metric to look at how valuations for the Russell Microcap compared to the Russell 1000, we found that, while the gap is not as wide, valuations for the Russell Microcap also finished June well below their long-term average compared to the Russell 1000.

Relative Valuations for Micro-Caps vs. Large-Caps Remain Below Their Long-Term Average Over the Last 25 Years
Russell Microcap vs. Russell 1000 Median LTM EV/EBIT (ex. Negative EBIT Companies), 6/30/01-6/30/26

Source: FactSet

Does the valuation picture bolster your optimistic view that small-cap can hold on to market leadership?

FG: It’s a key part of it, yes. I also think it’s interesting that so few commentators questioned the longevity of the recent large-cap leadership phase until valuations looked high—and that was more than a decade into the cycle. Yet small-cap’s current leadership is barely 16 months old, and we’re already hearing from some quarters that they can’t possibly stay on top. And the reasons aren’t grounded in any data. Some are saying that a rate increase will derail small-cap leadership, which, as Miles mentioned, is far from a guarantee, based on history. Others are convinced that the leadership will gravitate back to the biggest companies mostly because that’s the way things were prior to April of 2025.

It just goes to show what little attention is being paid to the long-term performance patterns of small-cap stocks and the more or less regular leadership rotation between small- and large-cap that goes back several decades, nearly a century, in fact. Our research, which goes back to the 1930s, shows that small-cap leadership cycles have averaged more than a decade. It’s also worth noting that the shortest small-cap leadership stint lasted roughly 10 years while the longest was 15 years. Of course, history seldom repeats itself, and, as Miles said when discussing rates, context matters a great deal, but these patterns have been present for many, many years. Based on what history shows, a lengthy period of small-cap leadership looks more likely than a reversion back to large-cap over the next few years.

Small-Cap and Large-Cap Market Cycles
Average Monthly Relative Performance for CRSP 6-10/CRSP 1-5 from 12/31/31 through 2/28/26 (%)

Past performance is no guarantee of future results.

Do you anticipate broader participation for those areas of the small-cap market that have lagged so far in 2026? What catalysts can boost the areas that have trailed the overall asset class?

ML: I definitely see the likelihood of broader participation. So many areas of small-cap have not yet participated in the rally. Normally when markets are hitting all-time highs, we’re all a little frustrated and bored because, as enjoyable as great performance is, we’re not finding a lot of opportunities—which for me is the most enjoyable part of the process. So the current moment is kind of weird—it’s the exact opposite because small-cap leadership has been so narrow. The sleeve of Royce Small-Cap Fund that I manage trades at less than 12 times earnings, which is not a metric any of us would expect to see given how well the overall asset class has performed.

I’m not sure what the specific catalysts will be, though I expect it goes back to what Frank was saying about earnings. Most small-cap companies will start reporting at the end of July and into August. Our hope is that investors will begin to recognize how compelling the combination of attractive valuations and steady or increasing earnings strength is for the many small-cap businesses whose shares haven’t really popped yet.

What areas of the market look attractively undervalued right now?

AP: I’ve been seeing appealing opportunities in almost every sector and industry over the last several months. To Miles’s point about valuations, once we cut out all the companies that have done well and experienced extreme re-ratings, that leaves roughly 70-80% of the index that we think is within reasonable valuation bounds. And in a growing economy, it’s a good setup. In the emerging quality space, I’ve seen a lot of companies that fit our criteria and are trading at what we think are really attractive multiples. These are one off, idiosyncratic investments, but I’ve been finding them in nearly every sector. Health Care is probably the sector where I’ve seen the largest number of discrete opportunities, but there’s no single area where I’ve looked and not found something interesting.

ML: Consumer Staples is a sector that until last year I hadn’t really invested in for several years, and where I’ve historically been very underweight. The same is true with Health Care—I’ve seen some interesting opportunities in that space over the last year or so. Insurance has been more or less left for dead. Part of that is the property & casualty cycle rolling over. I’ve seen several pockets of opportunity in that industry. Consumer Discretionary has also been looking interesting to me for a while and is looking more and more interesting. Historically, the best time to buy in this sector has been when all the consumer sentiment measures are terrible, and sentiment has been hitting new lows every time the survey data comes out. Broadly, any area of the market that’s kind of boring, has durable businesses that generate a lot of cash, and doesn't have a sexy story attached to it is worth investigating right now.

Can you highlight a holding in Royce Small-Cap Fund that has your long-term confidence?

ML: I’ll talk about Nomad Foods, which is headquartered in the U.K. and is the largest frozen food manufacturer in Europe. Two-thirds of the business is protein and vegetables, so despite being a packaged food company, Nomad is well positioned for the trends towards healthier eating. It’s a turnaround story with a new CEO who has a really strong track record in the space. For example, one of their initiatives is upgrading packaging to emphasize the protein content to catch the consumer’s eye. The category is growing by low single digits, so Nomad has the wind at its back as it executes the turnaround.

Nomad Foods (NYSE: NOMD)
12/31/25-7/2/26

Past performance is no guarantee of future results.

Going back to what I mentioned earlier in our discussion; this is one of the cheapest stocks in the portfolio: it’s been trading at less than six times earnings. That’s an attractively cheap valuation, especially in the context of an almost 20% free cash flow yield and a 7% dividend yield. Nomad has also returned 13% to shareholders in the form of buybacks over the last 12 months, which equates to a 20% shareholder yield. Over time, I think it can be a mid-to-high-single digit earnings grower. I also like that there’s been a significant amount of insider buying over the last six months to the tune of more than $15 million, which is very high for most small-cap companies. Nomad has faced some very idiosyncratic issues over the last few years, so the stock has lagged, which gave us a chance to build a position at what I think were really low prices.

AP: I’d say Stevanato Group, which is an Italian multinational that makes glass containment vials and cartridges including those for injectable biologics that are inside of pen injectors and multi-use autoinjectors. It’s a regulated business, and Stevanato’s products get into the therapy when it’s going through the approval stage. Right now, a quarter of the business is GLP-1s. They've gone through a few billion dollar CapEx cycle across their their facilities in Fishers, Indiana and Latina, Italy.

Stevanato Group (NYSE: STVN)
12/31/25-7/2/26

Past performance is no guarantee of future results.

They've been signing up biologics customers to ten-year initial contracts with five-year minimum purchase agreements. The current mix of business is sort of mid- to low 20’s gross margin, while new high-value solutions lines ramp to well over 40% at maturity. There are two newer higher-value lines running right now with a few more ramping, and another twelve are going to be turning on in the next three years, and the CapEx investment costs are behind them. The stock has been trading at a low mid-single digit forward free cash flow yield, but free cash flow is likely to be tripling in the next three years.

Last, this opportunity exists because Stevanato faces competition from oral GLP-1s that are coming out, which has hurt the stock. But what people haven't realized is that these drugs will likely cost four or five times more to make than an injectable. There are also other complications in terms of the of active ingredient required be put in the pill to achieve the desired therapeutic effect, which causes unwanted side effects, so the uptake might not be as high as people are expecting. I think a lot of these challenges will be resolved over the next eighteen months. So this is a case where we should see the revelation of attractive long-term earnings power as some of these overhangs on the demand story get resolved.

What is your overall outlook for small-cap?

FG: My outlook just continues to be very constructive. I think that the market’s going to broaden out and that small-caps will continue to be the beneficiaries of stronger earnings growth and higher productivity in the economy. The earnings story continues to be the key because earnings growth ultimately drives long-term returns—and earnings fundamentals continue to improve for many small- and micro-cap companies. To be sure, consensus estimates are pointing to faster earnings growth ahead (as they have for the last several months).

Small-Cap’s Estimated Earnings Growth Is Expected to Remain Higher Than Large-Cap’s in 2026 and 2027
One-Year EPS Growth

Past performance is no guarantee of future results. Earnings per share (EPS) is calculated as a company’s profit divided by the outstanding shares of its common stock. The EPS Growth Estimates are the pre-calculated mean two-year EPS growth rate estimates by brokerage analysts. Estimates are the average of those provided by analysts working for brokerage firms who provide research coverage on each individual security as reported by FactSet. All non-equity securities, investment companies, and companies without brokerage analyst coverage are excluded. Source: FactSet.

ML: I think the cycle of small-cap beating large-cap has begun in earnest, and we’re at the very beginning. To the point Frank made earlier, I also think that it’s currently a ‘show me’ cycle. Certain people and institutions need more convincing that small-cap is where they should be thinking about investing for the long run. I don’t think enough people appreciate that when these cycles turn, they’re not typically 1-, 2-, or 3-year cycles but tend to last anywhere from 5 to 15 years. I also think that active management has a great opportunity to really shine in this small-cap leadership cycle.

AP: I’m piling on to the idea that small-caps are much more attractively valued than large-caps. I think that you can hang your hat on a lot of positive drivers for small-caps, especially better relative earnings growth, which is such an important and sizable driver.

CC: In addition to the strong fundamental case in favor of small-caps, there’s a flow of funds factor, too. Money must move from one market segment to another, and it seems that private equity and large-cap are stalling in terms of their fundraising because people are seeking alternatives. We know that there are trillions of dollars invested in Magnificent 7 that can be reallocated. And if revenue and earnings growth are slowing for these and other mega- and large-cap companies, which appears to be the case, then those investors can reallocate even a relatively small portion of those funds into small-cap and really boost returns.

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