Three big reasons why smaller stocks deserve attention

Are small- and mid-cap stocks poised for a glow-up? Smaller companies are trading at some of their steepest discounts in decades. Central banks are in easing mode. Merger and acquisition (M&A) activity has accelerated.

After years of being treated as the market’s wallflowers, small- and mid-cap—or SMID—companies could be ready to turn heads once again.

Yet the appeal of these stocks extends beyond tactical drivers. SMID stocks remain key diversifiers in investment portfolios and an opportunity-rich area for investors aware of their contours, evolving fundamentals, and market cycles.

In an era of extreme market concentration, three trends underscore why these often-overlooked stocks deserve attention.

#1 U.S. policy pivots: Setting the stage for a comeback

Much has been made of smaller stocks’ underperformance in recent years, with structural factors shrinking the universe of listed companies and hampering profitability at the index level—particularly in U.S. small-caps. While these headwinds won’t reverse overnight, the fundamental backdrop is becoming more constructive.

U.S. SMID stocks delivered solid earnings in the second quarter, and earnings growth is expected to inflect higher in the period ahead (Fig. 2). As the Federal Reserve signals rate cuts, smaller firms—which typically carry more debt and are more reliant on near-term refinancing than their larger counterparts—stand to benefit disproportionately from a lower interest rate burden and margin expansion. 

Furthermore, lower rates and an improved economic landscape are contributing to increased M&A activity and a revival in the initial public offering (IPO) market. Fresh capital flows and attention to emerging SMID companies could enhance valuations.

Trump administration policies also provide tailwinds. The One Big Beautiful Bill Act delivered a major tax boost for small businesses via immediate R&D and capex deductions. Deregulation offers another potential tailwind. The industrials, materials, and energy sectors—which are at the heart of the administration’s policy initiatives and feature more prominently in the U.S. SMID universe—could be the biggest beneficiaries.

However, investors should remain vigilant about tariff risks and the broader U.S. economic outlook.

#2 Europe’s reawakening: Momentum for smaller companies

Across the Atlantic, Europe is recalibrating its economic strategy in response to U.S. tariff threats and shifting foreign policy. This is opening the door to increased fiscal spending, pro-innovation reforms, and renewed investment in Europe’s more cyclically oriented economy. Attractive valuations, a comparatively lower exposure to trade risks, and a weaker U.S. dollar have created a more favorable environment.

Importantly, smaller companies outside the U.S. generally boast stronger return on equity and other fundamental metrics than their U.S. peers. As Europe reinvests in its domestic economy, smaller companies—which are generally more tied to local services and supply chains—are well positioned to capture the benefits of shifting spending patterns and productivity gains.

#3 The AI halo effect: New growth engines on the horizon

While the initial wave of AI innovation has supercharged mega-cap tech stocks, the next phase could see smaller firms seizing opportunities to disrupt their industries through AI applications.

Additionally, the long-term buildout of AI infrastructure provides a “picks and shovels” opportunity in the SMID space—think electrical equipment makers, heating and cooling specialists, and niche manufacturers. Taiwan’s semiconductor ecosystem, for example, is rich with smaller tech firms poised to benefit from sustained AI-driven capital spending.

However, caution is warranted. Many smaller U.S. stocks linked to technology themes such as quantum computing have soared amid speculative rallies in high-risk and low-quality segments. Current valuations in these areas warrant a thoughtful approach, one that looks beyond the hype and focuses on companies with genuine, durable advantages in leveraging emerging technologies.

An active edge

History shows that periods dominated by concentrated large-cap leadership—like the “Nifty Fifty"¹ and dot-com bubbles—can give way to meaningful stretches of SMID stock outperformance (Fig. 3).

With Wall Street analyst coverage of smaller companies having declined over the past decade, active investors may have a real opportunity to gain an information edge through in-depth research. Identifying companies with pricing power—often those operating in niche or business-critical areas—could be particularly rewarding, especially if inflation stays elevated. This underscores the importance of carefully analyzing balance sheets, cash flow resilience, and evolving business models in the age of AI.

Looking for a spark

Valuation-aware investors have been frustrated that decades of SMID discounts haven’t led to a sustained mean reversion. Brief rallies led by the most speculative names have been followed by disappointment.

However, valuations remain compelling, and conditions appear to be supported by policy moves, cyclical upswings, prospects for increased M&A and IPO activity, and AI-driven disruption.

For investors willing to take a multiyear horizon, revisit strategic allocations, and seek out tomorrow’s breakout stars, this could be the makeover moment they’ve been waiting for.