Royce: Small and micro caps outperform in 2Q26; leadership likely to continue
Since the market's last low on April 8, 2025, the Russell 2000 has gained 74.5%, while the Russell Microcap is up 108.4% / Photo: Facebook / NYSE
Small- and micro-cap stocks posted a strong second quarter, with the Russell Microcap index gaining 25.6% and the Russell 2000 advancing 21.5%. Smaller companies have emerged as market leaders and are likely to maintain that leadership moving forward, notes Francis Gannon, cochief investment officer and managing director at Royce Investment Partners. In a recent recap on the second quarter, he outlined the best-performing sectors and the factors he believes will drive small caps in the coming months.
Micro caps lead the market
The Russell Microcap rose 25.6% in the second quarter. The Russell 2000, the benchmark for small caps, gained 21.5%, versus 15.1% for the large-cap Russell 1000. The Russell Top 50, which tracks the largest U.S. corporations, advanced 10.7%. For comparison, the tech-heavy Nasdaq Composite gained 21.6%.
The U.S. stock market largely recovered from its weak first-quarter performance, with the second quarter proving especially favorable for small- and micro-cap names, Gannon wrote. Despite ongoing geopolitical tensions, persistent inflation, and continued volatility in energy prices, the rally was supported by AI infrastructure investments, resilient consumer spending, and improving corporate earnings.
Leadership by smaller companies has extended beyond a short-term phenomenon. Over the last 12 months, the Russell 2000 has gained 40.8%, while the Russell Microcap is up 58.5%. Gannon also described the rebound from the most recent market low on April 8, 2025, as particularly impressive. Since then, the Russell 2000 has surged 74.5%, the Russell Microcap 108.4%, the Russell 1000 52.8%, the Russell Top 50 49.0%, and the Nasdaq Composite 73.1%.
Energy the only laggard
Ten of the 11 sectors in the Russell 2000 posted positive returns during the second quarter, while only one finished in negative territory. IT, industrials, health care, and financials delivered the strongest performance, Gannon notes. Energy made the largest negative contribution because of the war in Iran and its impact on global energy supplies. Within tech, the strongest gains came from semiconductors & semiconductor equipment, software – which rebounded after a weak first quarter – and electronic equipment, instruments & components.
Growth drivers moving forward
Royce expects small- and micro-cap stocks to continue outperforming. Gannon says concerns about the impact of higher interest rates are overstated. "Finally, the sensitivity of small-cap performance to rate hikes (or cuts) is not as closely correlated as many assume; it also tends to discount (if not ignore) the performance of small-cap companies with little or no debt," he noted.
Most important from our standpoint is that the combination of small-cap valuations and earnings should be more than sufficient to keep the asset class in the leadership role. As we always do, we looked at the data, which in this case means our preferred index valuation measure, EV/EBIT... The valuations for small-cap versus large-cap, even after more than a year of robust returns, were still close to their lowest levels versus the Russell 1000 in 25 years at the end of June.
However, Gannon argues earnings growth ultimately drives long-term investment returns and notes that earnings fundamentals continue to improve for many small- and micro-cap companies. The AI boom has been the catalyst for that recovery, as smaller companies supply tools, components, and services to larger partners across the AI supply chain, ranging from semiconductor components to energy providers critical to data center operations.
During 2025, we observed that the AI buildout — which up until roughly the first few months of 2025 had mostly benefited mega-cap companies such as Alphabet, Apple, Microsoft, and Nvidia — was beginning to filter through to those small- and micro-cap companies that were selling into the AI supply chain.
Royce expects earnings growth for smaller companies to continue outpacing that for large caps through the end of 2027. It forecasts EPS growth of 54% for Russell 2000 companies for 2026, versus 19% for Russell 1000 companies. For 2027, it projects EPS growth of 31.8% versus 15.3%, respectively.
This combination of relatively more attractive valuations and ongoing earnings strength bolsters our conviction that the current environment continues to offer many compelling opportunities for active, fundamentals-driven investors with a long-term horizon.
Volatility likely
Gannon cautions that periods of strong market performance are almost always accompanied by bouts of higher volatility as investors reassess their positions and investment decisions. Even so, Royce does not view volatility as a warning sign or a precursor to a major correction. "We have always seen volatility as an ally, a common market force that allows disciplined investors with a long-term horizon to take advantage of short-term movements in order to potentially enhance market-beating results over the long run," Gannon notes.
