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In their latest Insight – Extreme Valuations & Durable Fundamentals: The Case for Small Caps Globally, Pzena Investment Management argues that the massive concentration of returns among a handful of mega-cap names has left small-cap stocks globally at “an attractive entry point relative to large caps”.

Despite having risen more than 140% since the pandemic lows, they note that “global small caps trade at near record lows relative to global large-cap stocks.” Small caps now represent “only 1.2% of total U.S. market capitalization, close to a 100-year low and well below the historical average of 3.6%.”

The report traces how the “initial recovery after the Global Financial Crisis was marked by slow growth and very low financing costs,” fueling venture capital and growth investing while small caps held steady.

Yet as trade uncertainty and rising rates took hold, “expensive growth companies that promised steady earnings gained favor, and from there, the valuation gap widened.” Even after the 2022 decline, “mega-cap growth stocks quickly regained leadership on enthusiasm for artificial intelligence,” widening the divide.

Over the past decade, “global small caps delivered a decent annual return of 9.6%, compared with 12.4% for global large caps.” The biggest gap has been in the U.S., where “U.S. large caps returned 15.0% per year, while U.S. small caps returned only 9.8%.”

Pzena notes that while the disparity is striking, “history suggests such cycles are part of long-term market patterns rather than permanent shifts.” Fundamentally, “small caps generated significantly higher combined free cash flow growth and dividends… in excess of 500 basis points per year more than large caps.” The difference in returns, they argue, “has been driven entirely by sentiment and relative multiple expansion.”

Looking forward, they write, “consensus forecasts show small caps continuing to outpace large caps over the next three years, and beating the Magnificent Seven in 2026 and 2027.”

While leverage and unprofitable companies are real risks, “both issues can be managed; active investors can avoid the weakest balance sheets and the persistently loss-making companies.”

The letter also addresses the decline in listed companies, noting that “over the past 30 years, the number of listed U.S. companies has fallen by 40–50%,” but that “most of the decline has taken place in the micro-cap space.” Private equity, they add, “can serve as a stabilizing force, stepping in as a buyer during periods of small-cap weakness.”

Pzena concludes that “small caps have endured a decade in which they were overshadowed by mega-cap growth stocks and weighed down by sentiment, higher rates, and structural shifts in capital markets. Yet fundamentals remain intact.”

With valuations “near historic lows” and prior cycles showing similar setups before strong recoveries, they believe “investors are well positioned to benefit from the next phase of the cycle.”

Read the entire report here.

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