How small caps might turn their performance around in 2025

With only a few pieces left to fall into place, the stage could be set for small caps to return to the forefront of investors’ favour after years of battling inflationary pressures and recessionary fears.

Jim Shore, Senior Client Portfolio Manager at American Century Investments, said several changes to macroeconomic conditions towards the end of last year have seen small caps shift back into the spotlight, particularly after the US election where investors expected stocks to benefit from Donald Trump’s policy promises and economic administration.

“Expectations for continued rate cuts by the Federal Reserve (Fed) and other central banks have also contributed to favourable conditions for small-caps. Smaller companies often carry more floating-rate debt than their larger peers and may benefit as interest rate pressures ease,” Shore said.

“Despite this stretch of outperformance and an improving outlook, global small-caps continue to trade at a discount compared with large-cap stocks. In our view, current valuations could make this an attractive entry point to offset concentration risk in mega-cap stocks.”

Shore also described five main trends that would support an environment where small caps would thrive and their profit would grow:

• Reshoring and Nearshoring

“The incoming Trump administration has threatened to increase tariffs, which could lead more large companies to bring their supply chains closer to home. Small-caps may benefit from increased capital spending tied to reshoring and nearshoring.

“Historically, small-cap companies have tended to generate more revenues domestically and tend to be less exposed to global supply chains, potentially reducing their tariff risk.

“Increased reshoring may benefit companies like Clean Harbors, a provider of environmental and industrial services. Accelerating reshoring would increase U.S. manufacturing activity, a key driver of Clean Harbors’ growth.”

• Artificial Intelligence (AI) and Data Centres

“The growth of AI is expected to continue fuelling demand for data centres and energy. While the Magnificent Seven companies have attracted more attention, we believe this trend will also help small-cap companies in multiple categories.

“Beneficiaries could include data centre operators and providers of energy-efficient cooling solutions, such as those developed by Modine Manufacturing. Data centers are Modine’s fastest-growing end market.”

• Electrification

“Increased electricity demand and capital spending tied to electrification may create opportunities. AI’s need for power is so great that existing infrastructure can’t keep up. Utilities are pouring more resources into their power grids and electrical transmission.

“AtkinsRealis, an engineering services and nuclear energy company, and Arcadis, a design, engineering and consultancy services provider, are likely beneficiaries. AtkinsRealis’ revenue growth is accelerating, and its service backlog reached a record high in 2024 driven by its nuclear energy division.

“Other potential beneficiaries include Capstone Copper, as increased electricity demand should increase the demand for copper.”

• Deregulation and Mergers & Acquisitions (M&A)

“While M&A and IPO activity declined in 2022 and 2023, lower interest rates and a more favourable U.S. regulatory environment may lead to more deals in 2025.

“Deregulation could boost capital markets activity, benefiting banks and boutique investment firms like Evercore.”

• Housing Bottlenecks

“Limited sales of existing homes and lower material costs could benefit home builders serving budget-conscious and higher-end buyers. Examples in this arena include Champion Homes and Toll Brothers. Lower mortgage rates would further boost housing demand.”