Five potential drivers of small-cap earnings growth from Royce

Royce Co-Chief Investment Officer Francis Gannon outlined five factors that can drive small-cap earnings growth in a blog post. Royce Investment Partners has specialized in investing in small-cap companies since 1972 and traditionally specialized in businesses with sustainable models, strong balance sheets, and straightforward cash flows. 

Over the last several years, small-cap stocks lagged the broader market as higher interest rates, rising costs, and narrow mega-cap leadership compressed valuations and limited earnings visibility. “This dynamic, however, is beginning to shift,” Gannon writes, noting that small caps have started to outperform. Year to date, small caps have outperformed their large peers. Since the market low on April 8 of last year, the Russell 2000 has gained more than 50%, outpacing the Russell 1000, which added around 40% over the same period. Despite improving sentiment, valuations remain discounted and fundamentals are starting to turn, Gannon says, identifying five factors that can drive earnings growth for smaller companies. 

Below Oninvest looks at these five factors.  

Interest rates

The interest-rate environment is one of the most important drivers. Small-cap companies are typically more sensitive to borrowing costs, and “small-cap companies typically carry more leverage and have greater exposure to floating-rate debt than their large-cap peers,” Gannon notes. As financial conditions become less restrictive, interest expense tends to fall more quickly for smaller companies, supporting earnings. “This pattern has been evident in prior easing cycles, when small-cap earnings growth accelerated relative to large-caps, often before the improvement was fully reflected in consensus estimates,” he adds.

Tax policy

Tax policy is also becoming more supportive. Provisions enacted in mid-2025 are improving after-tax cash flow for many domestically focused companies, particularly those without access to complicated international tax structures, Gannon notes. Incentives tied to capital investment and R&D support reinvestment, productivity gains, and margin expansion, factors that tend to matter more for smaller companies, especially those earlier in their growth trajectories.

Reshoring

Reshoring remains a durable structural trend as manufacturers prioritize resilience and proximity over cost gains. Demand continues shifting toward domestic suppliers and specialized service providers. “Many small-cap companies occupy compressed but critical positions in these ecosystems and directly benefit from incremental domestic investment, unlike multinational firms whose exposure is more diffuse,” Gannon writes.

Technology adoption

Technology adoption is another supportive factor not yet fully reflected in the market, particularly AI. For smaller companies, even incremental productivity gains can materially improve profitability. “For smaller companies with lean cost structures and high operating leverage, even incremental productivity gains can have an outsized impact on margins, creating a pathway to earnings growth that does not rely solely on revenue acceleration,” Gannon argues, adding that this becomes increasingly relevant as the economic cycle matures.

Deregulation

Deregulation could also act as a tailwind. “Compliance costs are largely fixed and so weigh more heavily on smaller companies,” Gannon writes. As a result, “any easing of regulatory burdens – across diverse economic segments such as financial services, industrials, energy, and health care – can improve margins and free cash flow for small-caps more meaningfully than for large-caps.”

History suggests that when earnings expectations begin to rise from depressed levels, small caps can deliver meaningful performance, Gannon points out. At the same time, dispersion within the segment remains high, and balance sheet strength, pricing power, and management quality remain critical.

“As experienced small-cap investors, we are admittedly biased – but our unshakeable conviction is that active and disciplined small-cap management will matter more and more as the cycle rolls on,” Gannon concludes.