Why small-caps could be poised for a comeback

By Darius McDermott on 18 February 2026 in Equities, Global

2025 was a year dominated by large caps. Across most major markets, a handful of mega-cap companies led market performance, and investors saw no need to dabble in smaller companies. AI was on everyone’s mind and larger companies appeared to offer greater exposure to its long-term growth. However, as the environment shifts, small-caps may have a better outlook from here.

The problems of excessive concentration in the US market have been well-documented. The top 10 companies in the S&P 500 now form almost 40% of its market capitalisation*. With the exception of Berkshire Hathaway, they are all technology companies* and, for the most part, dependent on the artificial intelligence trade.

A similar phenomenon has been seen in the UK market. The FTSE 100 showed strong gains last year, significantly outpacing small and mid-cap companies. The large-cap index rose 25.8% over the year, led by a handful of defence and financial companies*. HSBC and Barclays, for example, rose 48% and 75% respectively, while Rolls-Royce gained 106%. GSK and AstraZeneca, rising 35% and 31%, were also strong**. In contrast, the FTSE 250 rose just 13% and the FTSE Small-Cap 14.4%*.

In Asia, semiconductor and memory giants TSMC and Samsung have driven markets higher, as investors have looked around the world for other ways into the AI trade. Europe has been the only exception, where small and mid-cap performance has been more in line with large-caps.

There is another reason it has been tough for small-cap fund managers across the world. Alongside this preference for larger companies, markets have tended to prefer lower quality companies. These are not the natural hunting ground for active small-cap managers, who usually try to mitigate the risks of smaller companies by focusing on strong balance sheets, good cash flow and strong management teams.

Nish Patel, manager of the Global Smaller Companies Trust, says:

“Over the six months, the market became increasingly speculative with the lowest quality companies significantly outperforming the highest quality businesses. Unprofitable smaller companies rallied strongly as did those on the highest valuations. This was particularly challenging to our investment philosophy of taking a long term, conservative approach to investing in good quality, growing businesses.”

The only real areas of strength were those small-cap companies exposed to fashionable areas, such as aerospace and defence or the AI supply chain. Nish says: “Financial results from companies in the aerospace and defence sector revealed strong demand from customers as the West continues to increase its expenditure on defence after years of under-investment. Businesses linked to expenditure on AI and data centres also delivered impressive earnings.” He says that this extended to adjacent industries, such as power generation and nuclear energy.

There was also some stabilisation in the healthcare sector as some clarity around tariffs emerged. This brought renewed spending on research and development and smaller companies were beneficiaries. Nish says that takeover activity was brisk, with five companies in the portfolio receiving takeover bids in the period***.

The focus on large-caps has been extreme and smaller companies now look cheap compared with their larger peers and to their own history. Large-caps have been buoyed by the wall of money going into passive vehicles, but there are signs that is slowing amid worries over market concentration, the dominance of the US technology sector and the giant bet on AI.

Better times ahead?

Julia Scheufler, co-manager of the Janus Henderson European Smaller Companies fund, says: “Economic ups and downs tend to have a more immediate impact on smaller companies than on large ones. They’ve had a tough few years, but pressures are easing; inflation is down, wages are up, borrowing costs have stopped climbing. That’s good news for businesses that rely on domestic demand.

The team is still seeing opportunities, as spending on areas such as AI and defence filters through the system. In particular companies working behind the scenes on Germany’s upgrade should be beneficiaries. “Think IT specialists like Bechtle, ready to deliver Germany’s long-overdue digital refresh. Or Ströer, which stands to gain as consumer confidence improves, and advertising budgets grow. These aren’t household names, but they’re essential to modernisation – and that’s where opportunity often hides.”

This period of underperformance by small-caps versus large caps is the result of a combination of headwinds. Higher interest rates tend to hit smaller companies harder. Macroeconomic uncertainty led investors to favour large companies with global exposure and stronger balance sheets. However, there are signs of the trend reversing and small-caps beginning to outperform once more, according to David Walton, manager of the IFSL Marlborough European Special Situations fund.

This is spreading out from Europe into other markets. Since the start of 2026, the average fund in the IA North American Smaller Companies sector is up 4.7%, while UK Smaller Companies are up 3.8%. In the UK^, this has come as part of a broader resurgence in UK markets, and smaller companies are only around 1% ahead of the wider UK All Companies sector, but in the US, smaller companies are 5.2% ahead^.

Smaller companies may prove to be a natural ‘anti-AI’ trade, as investors hunt around for alternative sources of growth. It wouldn’t take a lot of capital in motion to move the dial for smaller companies. In the UK, for example, the aggregate market capitalisation for the FTSE Small-Cap index is £100bn^^. That puts it at just 2.2% of the market capitalisation of Nvidia.

Smaller companies look to be in a strong position to build momentum from here. They need large companies to exit the stage, and this may be happening as investors lose patience with AI spending. Lower interest rates and higher fiscal spending should also provide a favourable backdrop. Smaller companies should be a happier hunting ground in 2026.

*Source: index factsheet, 30 January 2026

**Source: interactive investor, 23 December 2025

***Source: half year report ended 31 October 2025

^Source: FE fundinfo, 9 February 2026

^^Source: FTSE Russell index series, 2019