In a recent CNBC appearance, Ed Yardeni of Yardeni Research explained why public small-cap stocks (like those in the Russell 2000 or S&P 600) have struggled to deliver earnings growth. His key point: the most promising small firms are being acquired by large-cap players before they grow into publicly listed standouts.
So where is this theory coming from?
The Earnings Gap
Yardeni points out that S&P 500 forward earnings have surged since mid-2023, while forward earnings for the S&P 400 and S&P 600 have largely flatlined. This divergence is has lasted longer than usual and is historically rare.
The Acquisition Pipeline
Instead of maturing and entering the public market, top-performing smaller firms often get eaten up by large-cap tech companies or other big acquirers. As a result, the public small-cap universe is left with a pipeline of slower-growing firms, suppressing aggregate earnings momentum.
The Broader Market
This theory aligns with other trends in the market today:
- Small caps are in the 12th year of a prolonged underperformance cycle, well beyond historical averages. CFA Institute
- Valuation spreads show small caps trading at discounts, yet investors remain drawn to large-cap tech and AI names. Morningstar
- Liquidity constraints, interest-rate risk, and sector exposures further weaken small-cap performance. MorningStar Indexes
What It Means for The Investor
Yardeni’s thesis emphasizes that the underperformance of public small caps is not just about short-term cycles, and more so on the structural shifts in how smaller companies are monetized. With the most talented firms going private or being bought early, the remaining small-cap stocks are less likely to deliver breakout growth.
At the same time, history suggests this dynamic eventually reverses. If interest rates decline, IPO pipelines reopen, or market sentiment shifts, small-cap stocks often have strong come backs. CFA Institute
I always like to come back to the Quilt chart, which demonstrates historical returns for various sectors. While small-cap stocks haven’t had the greatest go recently, it doesn’t necessarily mean the underperformance is set in stone.
What are your your thoughts on small-cap performance?
