Small-cap stocks present a compelling yet underappreciated opportunity for investors. The past year has reinforced key dynamics we highlighted in our previous whitepaper[1], particularly the dominance of select mega-cap tech stocks in passive investments, and the resulting valuation dislocations across the broader equity landscape. This imbalance has only deepened, with small caps continuing to trade at historically wide valuation discounts relative to their large-cap counterparts. While performance has lagged in recent years, the gap presents an attractive entry point for long-term investors looking for diversification within their exposure to equities.
Our outlook for small caps in 2025 and beyond is driven by a combination of valuations, macroeconomic conditions and key industry trends. Despite persistent inflationary pressures and an evolving interest rate environment, market resilience remains evident. At the industry level, structural factors such as increased M&A activity, reshoring, insulation from multinational dynamics, declining interest rates and shifts in corporate tax policy and deregulation create a compelling landscape for selective opportunities. In the final sections, our analysts provide further insights into the factors driving small-cap companies within specific industries and the opportunistic themes that lie ahead.
Beyond these fundamental factors, small-cap stocks remain a dynamic segment of the market – characterized by a broad and diverse investment set, a high proportion of unprofitable companies and limited Wall Street coverage. These inefficiencies create fertile ground for active management to uncover alpha, particularly in an environment where passive strategies may overlook idiosyncratic opportunities.
With valuations at an attractive discount, improving fundamentals and a strong track record of active management driving alpha, we believe our methodology is well positioned to capitalize on these dynamics.
Large Vs. Small: Historic Gap
From 2010 to 2017, small caps (Russell 2000) generally traded at higher forward P/E multiples than large caps (Russell 1000). Since 2018, however, the valuation gap has widened in favor of large caps, with a significant premium emerging from 2020 onward.
Over longer periods, forward P/E trends help reveal investor sentiment shifts. During risk-on periods, investors seek higher potential rates of return, which often justifies small caps commanding higher valuation multiples. In risk-off periods, investors prioritize stability and capital preservation, leading large caps to trade at a premium due to their more predictable earnings.
Over the past decade, the performance gap between the Russell 1000 and the Russell 2000 has widened significantly, driven by outsized returns from large-cap stocks.
A key factor behind this divergence is the Russell 1000’s heavy weighting in technology (~30%), a sector that has been a major driver of market gains. Large-cap technology companies have benefited from structurally higher margins, significant R&D investment, and capital-light business models centered around software and intellectual property. Additionally, the rise of passive investing has fueled a disproportionate flow of capital into broad-based ETFs and target-date funds, reinforcing momentum in large-cap stocks – an advantage that small caps have not similarly enjoyed.
Since 2015, the Russell 1000 has outperformed the Russell 2000 in all but one year. This persistent divergence suggests that small-cap stocks may be poised for a period of relative outperformance, particularly given the current valuation gap.
As small-cap earnings expectations stabilize and economic growth broadens beyond a handful of large-cap leaders, the performance differential between large and small caps has the potential to narrow.
Macroeconomic Backdrop
Donald Trump’s return to the White House as the second U.S. president to regain office after losing it has led markets to anticipate stronger economic growth. In November 2024, small-cap stocks initially led the equity market rally, outperforming large caps by over 450 basis points. However, the rise in long-term interest rates, driven by increasing growth expectations and inflation concerns, triggered a sharp reversal, with small caps underperforming large caps by more than 900 basis points since December 1st.
While the market continues to process implications for the new administration, the overall outlook for U.S. economic growth in 2025 remains robust. Consensus forecasts further growth in GDP, supported by anticipated fiscal stimulus, tax reforms and a renewed push for deregulation. Strong consumer spending, improving business investment and a more favorable policy backdrop are expected to drive economic expansion, even as markets continue to grapple with higher interest rates and inflationary pressures. This environment creates a favorable backdrop for U.S. equities, which tend to benefit from stronger domestic growth and pro-business policies.
Trends in Focus: Reasons to Own Small Caps
Small-cap stocks are poised to benefit from several key trends. An increase in mergers and acquisitions (M&A) can be a catalyst that helps unlock value for smaller companies. Reshoring efforts are bringing manufacturing and supply chains back to U.S., boosting local businesses. Unlike large multinational corporations, many U.S. small caps enjoy insulation from global economic and geopolitical volatility, making them more resilient in uncertain times. Additionally, potential U.S. corporate tax cuts and deregulation could provide a meaningful tailwind, enhancing profitability and supporting future growth. Lastly, a declining interest rate environment can be a favorable backdrop for small-cap stocks.
1. Increase in Mergers and Acquisitions (M&A)
Mergers and acquisitions (M&A) activity has been a key catalyst for small-cap stocks. The momentum seen in 2024 is expected to continue in 2025 and beyond, driven by macroeconomic and market-specific factors. These dynamics should fuel increased deal activity, making small companies increasingly attractive targets for strategic buyers.
- Attractive Valuations: A prolonged period of underperformance in small caps not only presents an opportunity for public equity investors but also creates a compelling buying opportunity for strategic acquirers. Depressed valuations present the opportunity for buyers to acquire small-cap companies at discounted prices, whether to enhance their growth pipelines or unlock strategic synergies.
- Private Equity Dry Powder: Private equity (PE) firms sit on record levels of dry powder. According to PitchBook[2], there is an estimated $1 trillion in unallocated capital just in the U.S. alone. PE firms look towards small-cap companies for bolt-on acquisitions or industry consolidation plays.
- Cost of Capital: While higher interest rates slowed M&A activity in recent years, a decline in rates should reinvigorate deal-making. A lower cost of capital enhances financing and credit conditions, giving buyers more flexibility for acquisitions. Improved financing benefits small-cap stocks by expanding their pool of potential acquirers.
- Deregulation: Pending M&A transactions can require approvals from agencies such as the Federal Trade Commission (FTC) and the Department of Justice (DOJ) in the U.S., or similar bodies in international markets. While the current market backdrop may complicate the dealmaking environment in the short-term, a Trump administration would likely ease regulations, reducing antitrust scrutiny and streamlining approvals, which could lower costs and boost corporate confidence in M&A.
2. Reshoring
While this trend predates COVID-19, the pandemic exposed critical vulnerabilities in global supply chains, accelerating efforts to bring production back to the U.S. With the new administration prioritizing domestic economic growth over the next four years, momentum in reshoring is expected to continue. However, the policy approach is likely to differ from the Biden administration.
Policy expected to be the administration’s focus will relate to deregulation, tax incentives encouraging domestic investment and broad tariffs to discourage outsourcing. These measures build on past reshoring initiatives, including the 2022 CHIPS and Science Act, which focused on supply chain resilience and infrastructure investment. With this persistent legislative push is the call for additional private sector, domestically based business investment.
For example, companies that rely heavily on outsourcing to take advantage of lower labor and material costs now face the threat of import tariffs, which could put them at a disadvantage compared to domestic competitors benefiting from a more business-friendly environment. As a result, companies are rethinking how they allocate capital domestically to stay competitive and drive growth. Shifts in management’s expected returns on core projects, such as acquiring and maintaining property, plants, equipment, and other key assets, could drive a transition from foreign to domestic operations.
Current street estimates anticipate continued momentum in capex growth of ~19% through 2026 mainly driven by the increasing investment in AI expansion and bolstering infrastructure necessary to meet power demand in the U.S.
The associated benefits of accelerating capital expenditure for small companies are best explained through examples:
3. Insulation from Multinational Dynamics
As shown in the figure below, the small-cap domestic revenue exposure of the Russell 2000 is disproportionately higher than that of the Russell 1000. This trend is primarily influenced by the relative sector weightings of each index and by company size.
Generally, smaller companies face a higher relative opportunity cost when expanding into international markets compared to their large-cap counterparts. As a result, small-cap companies are more likely to focus on domestic growth opportunities, while large-cap firms have greater resources to pursue international expansion. While entering international markets offers opportunity to capture a greater share of a company’s addressable market, it unlocks exposure to more complicated geopolitical dynamics.
- Trump & Tariffs: A key policy carried over from President Trump’s first term and a primary focus in the initial days of his second term, is the use of tariffs as a negotiation tool. In January, through the use of executive orders, Trump threatened to impose tariffs on Canada, Mexico and China if they failed to comply with national security provisions set for February 2025. While the precise sector- and company-specific impacts of these tariffs remain difficult to predict, businesses with greater exposure to channels affected by Trump’s tariff policies are likely to face negative tailwinds and elevated uncertainty.
- Persistent Strength in USD: Although not directly controlled by fiscal or monetary policy due to external factors, accelerating GDP growth and relatively high interest rates in relation to other nations are drivers of a stronger U.S. Dollar, all else equal. While this boosts international purchasing power by making imports cheaper, it simultaneously reduces demand for U.S. goods and services abroad as rising prices make exports less competitive.
4. Corporate Tax Cuts & Deregulation
In 2017, the Trump administration passed the Tax Cuts & Jobs Act (TCJA) which implemented several changes to the tax code for both individuals and more notably, corporations where the law reduced the top corporate tax rate from 35% to 21%. Though support for significantly reducing taxes on corporations has been mixed, the goal was to address a bipartisan concern relating to the U.S. having the highest corporate tax rate among developed nations. In addition to this tax reduction, modifications to the territorial tax system incentivized U.S. companies to repatriate foreign earnings, increase domestic based investment and discourage investment in low-tax jurisdictions.
As shown in the figure below, smaller, domestically focused companies incurred higher effective tax rates relative to larger less domestically focused companies. While both groups had a significant reduction in effective tax rates, TCJA policy changes helped narrow the gap between large and small companies.
Throughout 2025, attention will be on potential changes to the tax code as key provisions of the TCJA approach expiration in December. While we do not make specific predictions regarding policy updates, early signals from Trump’s second term suggest he may introduce a more accommodative reforms to benefit companies more heavily focused on operating and investing domestically. If so, we anticipate this will both directly and indirectly benefit smaller companies.
Regarding deregulation, Trump’s administration strives to halt the ‘regulatory onslaught’[3]. The administration has stated that overregulation stops American entrepreneurship, crushes small businesses and discourages innovation. Pro-small-business policies can benefit smaller companies by fostering innovation, new products, and fresh ideas, ultimately supporting sustainable long-term growth.
5. Declining Interest Rates
While the transition to multiple rate cuts in 2024 was widely expected to stimulate economic growth, persistent inflation and prolonged economic uncertainty have resulted in the Fed’s current interest rate trajectory to be more cautious. Still, the market anticipates that the Fed could cut interest rates at least two times in 2025. The trend of cutting interest rates would most likely continue into 2026.
Interest rate cuts can lead to lower borrowing costs, increased consumer spending, renewed investor risk appetite, higher valuation multiples for small-cap stocks and robust M&A activity.
- Borrowing Costs: Compared to larger companies, smaller companies typically face higher borrowing costs due to their higher perceived risk. Companies with floating-rate loans benefit from lower interest rates, reducing their borrowing costs and overall cost of capital. Access to low-cost funds can help these companies finance additional investments and manage debt more efficiently, potentially leading to higher growth rates.
- Consumer Spending: Lower interest rates benefit consumers by making loans and credit more affordable, leading to increased consumer spending. This directly boosts revenues for companies. Smaller companies, being more domestically focused, are typically more sensitive to changes in local consumer behavior compared to larger multinational corporations.
- Valuation Multiples: As interest rates decline, the present value of future earnings increases due to the lower discount rate. A lower discount rate leads to higher valuation multiples for stocks. For small-cap stocks, which are generally more reliant on earnings growth, the increase in valuation multiples is even more pronounced, as a significant portion of their value is based on future growth expectations.
- Investor Risk Appetite: In a low-interest rate environment, returns on fixed-income investments like bonds are lower. This often drives investors to seek higher returns in equities, including small-cap stocks, which are generally more volatile, but may offer the potential for higher returns.
Industry Trends in Focus – From Our Analysts
Tony Bancroft and Michael Burgio: Industrials – Aerospace and Defense
The aerospace and defense industry is poised for substantial growth in the coming years, driven by positive trends across both commercial and defense sectors. Key factors such as reshoring, mergers and acquisitions (M&A), insulation from multinational pressures, and corporate tax reductions are creating new opportunities, particularly for smaller companies. Despite short-term challenges, the long-term outlook remains positive.
Commercial Original Equipment Manufacturers (OEMs) continue to thrive in a market with strong demand, maintaining significant order backlogs. The global commercial aircraft fleet is expected to expand from 26,000 to over 50,000 aircraft by 2043, reflecting a compound annual growth rate (CAGR) of more than 3%. This growth is largely fueled by the recovery in passenger demand, with domestic Revenue Passenger Kilometers (RPK) and Available Seat Kilometers (ASK) surpassing 2019 levels.
On the defense side, U.S. defense spending is expected to reach $900 billion by 2025 (5% CAGR). This increase is driven by rising global security concerns, particularly in Europe and the Asia-Pacific region. NATO’s defense spending (excluding the U.S.) also rose 21% in 2024, highlighting the growing emphasis on defense modernization and procurement. Key growth areas include missiles and missile defense systems amid geopolitical tensions. However, budget uncertainties may pose short-term challenges, delaying critical spending and procurement decisions.
Increase in Mergers and Acquisitions (M&A): The aerospace and defense sector has experienced significant consolidation creating opportunities for small-cap firms, driven by several key factors:
- Supply Chain Resilience: The COVID-19 pandemic and subsequent global supply chain disruptions highlighted the need for vertical integration and control over key components. Companies are increasingly pursuing acquisitions to secure critical production capabilities, reduce dependency on third-party suppliers, and streamline operations.
- Technological Advancements: With growing demand for advanced technologies like unmanned systems, AI integration, and advanced propulsion, companies are seeking acquisitions to enhance their technological portfolios, particularly in defense electronics, cyber capabilities, and aerospace manufacturing.
- Geopolitical Dynamics: Rising international tensions, particularly in Eastern Europe and the Asia-Pacific region, have driven an increase in defense spending. In response, defense contractors are expanding their capabilities through acquisitions to meet the demand for systems such as missile defense, cybersecurity, and tactical aircraft.
- Financial Incentives: Corporate tax cuts, particularly in the U.S., have created an attractive environment for pursuing strategic acquisitions. Tax advantages encourage reinvestment in operations and bolster capital for M&A activity.
- Demand for Consolidation: Both the commercial aerospace and defense markets are seeing large companies consolidate smaller niche players to achieve economies of scale, reduce competition, and access new markets and customers.
Reshoring: Reshoring and vertical integration, especially among U.S.-based manufacturers, are helping companies mitigate risks related to global supply chains. This trend presents a tailwind for small-cap industrials and niche manufacturers, which are well-positioned to benefit as larger firms look to secure domestic suppliers. By bringing production closer to home, these companies reduce exposure to tariffs, regulatory changes, and geopolitical volatility, ensuring greater stability in uncertain times.
Insulation from Multinational Dynamics: The changing geopolitical landscape and rising nationalism are driving a focus on insulating supply chains from multinational risks. Ongoing trade tensions, especially between the U.S. and China, and potential shifts in U.S. foreign policy pose risks for global aerospace companies.
Corporate Tax Cuts: Corporate tax policy plays a crucial role in shaping investment strategies within the aerospace and defense sector. A U.S. tax cut would create a favorable environment for companies to reinvest in domestic manufacturing, research, and development. The reduced corporate tax rate boosts profitability, which is especially important for capital-intensive industries like aerospace and defense.
Tax cuts encourage investment in technology, infrastructure, and workforce development, enabling companies to scale production and meet growing demand in both the commercial and defense sectors. Moreover, these incentives are likely to spur additional M&A activity, benefiting small-cap takeout targets as companies seek to capitalize on favorable tax conditions to acquire assets that support long-term growth.
Brian Sponheimer: Industrials – Capital Equipment
Areas within the Industrials space are uniquely positioned to benefit from trends we expect to become more important throughout 2025.
Reshoring: Already a trend that began with the examination of supply chain resilience as a result of COVID, moves to investment in US manufacturing capabilities benefit small-cap industrial companies particularly well on a comparative basis as increases in revenue will have an outsized impact on income statements. We would expect much of the slated investment in areas such as Chip manufacturing and infrastructure investment to continue throughout 2025, enabling industrial-driven companies to mitigate short-term issues related to political negotiations.
Corporate Tax Cuts: Both corporate tax cuts and tax reform in general are likely to have major positive impacts on small-cap industrials, which tend to be more US-centric in their revenue generation. Therefore, any major tax legislation that reduces the burden of taxation on companies generating more of their income domestically will be particularly powerful. Further, the return of full bonus depreciation and other pro-growth tax reform dynamics are likely to assist companies, such as those within the rental equipment space, where purchases of capital equipment would be fully tax deductible in Year 1.
Deregulation: An emphasis on removing red tape and speeding up the time from design to permit should enable greater manufacturing and construction activity, particularly for companies either investing in or utilizing capital equipment.
Tim Winter: Utilities – Electric & Gas
We expect the structural dynamics of growing technological use, artificial intelligence, manufacturing on-shoring, and decarbonization to benefit small-cap U.S. electric and gas utility stocks. After two decades of flat growth, U.S. electric demand is set for its fastest growth since the 1950-70s. Utilities are shifting to expansion mode, driving higher capital investment, rate base growth, EPS growth, and consolidation.
Increase in Mergers and Acquisitions (M&A): Since 1995, the U.S. electric and gas utility sector has been consolidating with over 155 acquisition announcements and 124 completed deals. Further consolidation is being pushed by even higher capital investment budgets and the benefits of economies of scale. The combination of accelerated energy demand and decarbonization results in double digit rate base growth and material debt and stock issuance. Smaller utilities with smaller balance sheets need help undertaking larger projects. Large global infrastructure players value the existing infrastructure, and an acquisition represents a ticket to participate in the growth potential.
Reshoring: Data centers, onshoring and electrification drive growing electric demand. The global ‘arms race’ for AI superiority requires massive new power hungry data centers. Mega-cap tech companies (hyperscalers) are aggressively courting electric utilities to build the infrastructure to power mega-data centers, some of which use as much power as small cities. In addition, ongoing electrification and manufacturing on-shoring are adding to electric demand. Regulated electric utilities benefit from selling existing power capacity, adding power capacity (including batteries) and upgrading/expanding the transmission and distribution network.
Politicians and public utility regulators support the investment for economic and tax base reasons, but also the greater demand helps overall customer affordability. Meeting demand requires a more economical approach to clean energy, which means more gas-fired generation, nuclear development, and ongoing renewable development. We expect the relaxation of some environmental and regulatory rules to help “green light” an ”all of the above” energy development strategy.
Insulation from Multinational Dynamics: For the most part, electric and gas utilities are regulated monopolies and insulated form multi-national dynamics and tariffs. Should tariffs lead to higher supply costs, the higher costs are passed through to customers through higher rates. In addition, the local customer base and assets minimize exposure to geopolitical risks, volatile foreign exchange markets, and complex international regulations.
Corporate Tax Cuts: U.S. regulated electric and gas utilities “pass-through” higher corporate tax rates, which means customer bills are adjusted “up or down” to recognize a change in tax rates. A lower tax rate means lower customer bills. Lower customer bills generally mean more constructive rate orders. PUC’s set utility profit levels (represented by allowed returns on equity ROE’s) based off interest rates and allowed ROEs to go up or down with changes in interest rates. As a result, utility earnings growth potential improves as it invests more in rate base (infrastructure) even though its allowed ROE remains stable.
The 2022 Inflation Reduction Act (IRA) provides substantial tax credits (30-50%) investment credits on clean project investment and/or production. Despite negative campaign rhetoric, we do not expect IRA repeal and expect clean energy (wind, solar, and battery storage) tax credits to remain intact. Nonetheless, tax credit changes would have a minimal impact on most regulated utilities given that higher costs would be passed on to customer bills.
Themes in Focus – From Our Analysts
Sarah Donnelly: Theme – Water Infrastructure
We expect that the issues confronting water systems, such as scarcity and quality, will contribute to growth in infrastructure spending over the next couple of decades. The EPA estimates $625 billion in water upgrades are required in the U.S. In anticipation of these dynamics, we are emphasizing the theme of Water Infrastructure.
- Infrastructure resilience. Water infrastructure in the U.S. is old and requires upgrading to ensure consistent access to affordable water. Nearly 150,000 municipalities and utilities are responsible for more than 2.2 million water mains and pipes with an average age of 45 years. Meanwhile, every two minutes there is a water main break, which is costly. Such issues are driving demand for products such as pipes and valves but also for new technology to measure flow and pressure to better maintain water systems.
- Regulatory limits. More stringent regulations were announced by the EPA, which mandates minimum standards for drinking water. Regulations have reduced acceptable levels of toxins, such as arsenic and PFAS. Accordingly, water systems are deploying products and processes for water quality monitoring and treatment.
- Labor shortage. There is a shortage of skilled labor which is costly for operators of not only municipal water systems but also commercial and institutional buildings. The industry is seeing a greater adoption of technology and digital solutions to compensate for it which is contributing to growth across digitally connected or “smart” equipment.
- Government funded. The Infrastructure Investment and Jobs Act (IIJA) of 2021 allocated more than $50 million to improve water and wastewater infrastructure in the US and yet only a fraction have been spent thus far, leaving a long runway of growth. Additionally, most products need to meet the specifications enacted by the Build American Buy America Act, an advantage for domestic manufacturers.
Christopher Marangi: Theme – Live Entertainment & Sports
The media industry has undergone an acceleration in secular change as technological developments have disintermediated traditional content gatekeepers (e.g. cable and satellite providers, cable networks and theaters) and consumers have shifted their preferences. In anticipation of these dynamics, we are emphasizing the theme of Live Entertainment & Sports.
- Sports are tribal. Sports assets are scarce with a semi-fixed number of teams in each major league. Fandom tends to be economically resilient, relatively immune from political turmoil and cross a wide range of demographics. The resulting durability of this asset class has long been recognized by the wealthy and explains a 16% CAGR for team private market values from 2013 through 2023. Recent institutional interest in the space should augment asset values going forward.
- Viewership and thus value accruing to owners of live event intellectual property (IP). For the last several years, sporting events have accounted for more than half of the top 100 programs in the US. The ability of sports to aggregate large audiences that generally lack the ability to skip ads has attracted the attention of advertisers and media distributors alike, with the NBA, WWE, Formula One and other events inking record rights deals with both traditional media and tech firms.
- COVID accelerated a preference, especially among younger consumers, for “experiences over things.” Consumer spending on live entertainment and sports grew at a CAGR of 8.0% from 1959 through 2023, outpacing personal consumption expenditures of 6.6%. That growth accelerated to over 20% post-COVID; while “revenge” travel and concert attendance will likely moderate, growth in those categories should continue to substantially exceed general consumption, especially as remote work and the adoption of artificial intelligence increase leisure time and the need for human connection.
Charles LaRosa and Cameron Acito
Value Investment Team
clarosa@gabelli.com | cacito@gabelli.com
[1] “Small Caps Are Beautiful: 2024++ November Insights,” Gabelli Funds
[2] “US PE Breakdown,” PitchBook, accessed March 18, 2025, pitchbook.com
[3] “Fact Sheet: President Donald J. Trump Launches Massive 10-to-1 Deregulation Initiative,” The White House, accessed March 18, 2025, whitehouse.gov
This whitepaper was prepared by Charles LaRosa and Cameron Acito with the assistance of Tony Bancroft, Michael Burgio, Sarah Donnelly, Christopher Marangi, Brian Sponheimer and Tim Winter. The examples cited herein are based on public information and we make no representations regarding their accuracy or usefulness as precedent. The author’s views are subject to change at any time based on market and other conditions. The information in this report represent the opinions of the individual author as of the date hereof and is not intended to be a forecast of future events, a guarantee of future results, or investments advice. The views expressed may differ from other Portfolio Managers or of the Firm as a whole.
As of December 31, 2024, affiliates of GAMCO Investors, Inc. beneficially owned less than 1% of all companies mentioned.
