The Case for Small Cap Selectivity

Smaller stocks surged in the second quarter, outperforming their large cap analog for the second consecutive quarter, as easing Middle East tensions buoyed investor confidence. Similar to trends in the large cap space, smaller-stock index performance has been quite concentrated, with energy leading in the first quarter and tech rebounding in the second.¹

The capital investment to build out artificial intelligence (AI)-related infrastructure has been a source of support across markets. Spending on data-center software and information processing equipment relative to GDP, which now exceeds the dot-com peak, is forecast to continue.² Even if spending moderates, the long-term nature of projects like data centers suggests hyperscaler capex may be a source of support for smaller companies.

We think the sharp run-up in certain sectors reinforces the critical importance of exercising strict valuation discipline. However, we are excited about undervalued opportunities in sectors like in healthcare or consumer staples, or where we can identify more idiosyncratic turnarounds.

In addition, the reopening of the initial public offering (IPO) market in recent quarters has increased the number of stocks in our universe.⁴ Moreover, there is a vigorous pipeline of mature, high-profile companies and smaller portfolio companies from private equity firms. Additionally, companies that postponed IPOs due to government shutdowns could reemerge, facilitated by a benign regulatory environment focused on increased capital access and reduced compliance burdens.⁵