Valuations are attractive, but this time there’s more
At the 14-year mark, the current outperformance cycle by US large-cap stocks over small cap is well past the historical 10-year average. US small and mid-cap (SMID) companies have been out of favour since the pandemic due to the high-interest rate environment, growing geopolitical tensions, recessionary concerns and the dominance of AI-related names, all of which have created an attractive valuation distortion. US SMID companies should trade at a premium due to their higher growth potential, but they are currently trading at a 30% discount to their large-cap peers and at a discount to their own history.1
These companies are significantly under researched relative to large caps, with five or fewer analysts covering 43% of the Russell 2500 Index – a benchmark for US small-cap stocks. This information inefficiency creates an exciting opportunity for active managers to generate alpha by exploiting valuation dislocations through bottom-up research.
While valuation alone rarely triggers a rotation, the current macro, market and policy backdrop suggests that this time, it could be different.
Figure 1: Forward positive price-to-earnings - US SMID vs US large caps
Macroeconomic catalysts: Rate cuts are real, and not just talk
After a prolonged period of monetary tightening, the US Federal Reserve (the Fed) initiated its long-anticipated rate-cutting cycle in September 2024. While progress stalled in early 2025 due to persistent inflationary pressures and more cautious policymaking, recent dovish signals from Fed Chair Jerome Powell have reignited market expectations for renewed easing in the latter half of the year. It is widely expected that the Federal Open Market Committee (FOMC) will cut rates by a quarter point at the 16-17 September meeting.
This shift is particularly supportive for US SMID companies, which tend to outperform in environments where monetary policy is loosening. Historically, in the eight rate-cutting cycles since 1979, US small caps have outperformed their large-cap peers by an average of 6% in the 12 months following the first cut in rates – a powerful precedent for investors seeking cyclical upside.
Figure 2: Federal Reserve policy rate expectations
The existing policy divergence between the Fed and the European Central Bank (ECB) also adds a layer of relative attractiveness. While the Fed retains flexibility to ease further, the ECB has signalled that it is approaching the end of its rate-cutting cycle. This divergence enhances the appeal of US equities, particularly SMID caps, as global capital seeks more accommodative environments. In effect, the US becomes a more attractive destination for risk capital while tighter European policy may dampen investor appetite in that region.
While the Fed retains the flexibility to ease policy, we do not expect interest rates to return to the ultra-low levels that characterised the post-Global Financial Crisis (GFC) and early Covid periods. In this environment, companies with strong balance sheets, pricing power and consistent cash flow generation are better positioned to navigate elevated financing costs and macro volatility.
In the eight rate-cutting cycles since 1979, US small caps have outperformed their large-cap peers by an average of 6% in the 12 months following the first cut in rates.
Market catalysts: Earnings momentum is accelerating
Consensus earnings growth expectations for the US SMID class now exceeds those of its larger-cap peers and the so-called ‘Magnificent Seven’ cohort of mega-cap tech stocks – marking a potential inflection point in market leadership.
While the Magnificent Seven have driven much of the recent performance through multiple expansions and the AI-driven narrative of late, their earnings growth is expected to normalise. In contrast, US SMID – with its higher domestic focus and leverage to a cyclical recovery – is poised to deliver stronger bottom-line growth.
Figure 3: Earnings growth (year-on-year) expectations
The superior earnings growth potential of US SMID stocks could help to close the relative performance gap and coupled with the valuation distortion and dovish market expectations, could provide an attractive entry point for US SMID investors. Alongside improving earnings momentum, the policy backdrop is also turning increasingly favourable for these companies.
Policy catalysts: A pro-SMID policy agenda
The return of US President Donald Trump to the White House has reignited focus on domestic growth, deregulation and industrial revitalisation – all inherently supportive of US SMID companies, the backbone of the US economy. Following Trump’s re-election in November 2024, US SMID caps rallied 7.2% – outperforming large caps and reflecting investor optimism around pro-growth policies.2
The ‘America First’ agenda prioritises domestic production, creating a uniquely supportive environment for US SMID companies which are significantly more domestically focused than large-cap companies and directly benefiting SMID-dominated sectors like industrials and materials.
Secretary of the Treasury Scott Bessent’s 3-3-3 plan, which includes the ‘One Big Beautiful Bill’ Act (OBBA), is poised to boost US economic performance and should disproportionately benefit US SMID companies. OBBA is particularly constructive due to tax deductions and regulatory relief. These companies pay closer to full US corporate tax rates relative to their larger-cap peers, so any reduction would directly boost after-tax earnings and free up capital for reinvestment.
Additionally, regulatory easing would reduce compliance burdens that SMID companies often struggle to absorb. This would enhance operational flexibility, improve margins and unlock growth potential.
In parallel, the backdrop of falling interest rates and attractive valuations sets the stage for a pickup in mergers and acquisitions (M&A) activity. Historically, SMID companies have been central to global deal-making with 95% of all M&A transactions involving a SMID business3. This adds a layer of optionality and upside for investors, as consolidation can accelerate growth and drive shareholder value.
The evolution of AI – it’s not just large cap
The transformative power of artificial intelligence (AI) is not confined to the tech giants. Across the SMID landscape, a growing cohort of companies are harnessing AI to drive innovation, unlock operational efficiencies and create new market opportunities. For investors, this presents a compelling chance to gain exposure to the evolution of the AI ecosystem – often at more attractive valuations, with greater upside potential and, importantly, offering diversification.
US SMID firms play a critical role in enabling the infrastructure behind AI. From fibreoptic components and advanced cooling systems for data centres, to precision tools for semiconductor manufacturing and testing – these companies are supplying the essential building blocks that power AI’s rapid expansion.
nVent Electric is a critical supplier to AI data centres, delivering scalable liquid cooling solutions which enable high-performance computing environments. Teradyne, a leader in automated test equipment provides the advanced testing solutions required to validate and optimise AI chips and ensuring performance and reliability. Additionally, its robotics division has launched AI powered ‘cobots’ and autonomous mobile robots to bring physical AI into real-world settings.
Beyond AI infrastructure, many US SMID companies are leveraging artificial intelligence internally to enhance efficiency, reduce costs and improve service delivery. These firms are integrating AI into their core operations – not just as a technology upgrade, but as a strategic enabler of productivity and scale. Axon Enterprise, a leader in public safety technology, is using AI to transform how law enforcement agencies manage time and resources. Its generative AI tool, Draft One, automates police report writing, saving officers hours each week and allowing them to focus more on community engagement. Axon also employs AI for real-time translation, smart video auditing, and automated licence plate recognition – streamlining workflows while maintaining human oversight.
US SMID’s dual role – as both enablers and beneficiaries of AI – uniquely positions these companies in the value chain offering investors diversification within the AI tailwind.
Conclusion
US SMID caps are entering a new phase of leadership, with attractive valuations, improving earnings, supportive policy and evolving AI adoption. For investors seeking diversified exposure to domestic growth and innovation, the time to rotate is now.
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This information does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments.
1 Bloomberg, as at 31 August 2025.
2 Bloomberg, as at 30 November 2024.
3 Bain & Company, Global M&A Report 2025.
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