Does the small-cap effect still work globally?

The ‘small-cap effect’ refers to the notion that smaller companies tend to outperform large ones over the long term. But does it still hold true today?

We are currently in the second longest drawdown (when an asset or stockmarket fails to return to its previous high) for UK small caps since the mid 1950s¹ and the underperformance isn’t confined to these shores. This helps to explain why global smaller companies now trade at a significant valuation discount versus large caps².  

Global smaller companies' valuation premium/discount versus global large caps

Source: Bloomberg as at 2 February 2026

And yet, just like in the UK, global smaller companies have outperformed over the long term, on average delivering an additional 3.2 percentage points per year of returns over large caps from 2000 to the end of 2024³. 

Annualised small-cap premium (%) around the world, 2000-2025

Source: MSCI, Scott Evans and Paul Marsh, Deutsche Numis

Small-cap investors who have focused on ‘value’ (companies that are cheaper than the stockmarket) rather than ‘growth’ (companies growing faster than the stockmarket) have benefited from a further boost to long-term returns⁴.  

Value investing has worked in small caps

Source: Morningstar as at 31 January 2026. Net return in dollars. 

So why the recent lacklustre performance of smaller companies, or rather – and this distinction is important – of their share prices?  

What we have seen in the past few years is a surge in popularity of the mega caps (companies with a market capitalisation above $200bn), particularly those in the US. The Magnificent Seven (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla) tech companies represent more than a quarter of the MSCI World index⁵ and the US more than 73%⁶. We believe this concentration of money into a handful of companies means many other areas – including small caps – have been overlooked. Share prices have suffered as a result.  

The relative performance of small caps tends to move in cycles⁷, so given they have trailed large caps since 2020, now would seem like a good time to invest, in our view. 

Diversification benefits of small caps 

Aside from the valuation argument in favour of small caps, we think they also offer some important diversification benefits.  

In a global context, we regard any company with a market value of less than $15bn as a small cap. This leaves us with a potential investable universe of about 5,000 names⁸, giving us plenty of options in our search for cheap companies with attractive growth prospects and low levels of debt.  

We think this is especially important in today’s environment. A defining feature of the 47th US presidency, as with the 45th, is the steady advance of anti-globalisation (the reversal of global interdependence). This heightens the appeal of smaller companies on several fronts. Perhaps most obviously, many such businesses around the world tend to have a domestic focus – which potentially reduces the impact of global tariffs.  

As Canadian prime minister Mark Carney pointed out at Davos recently: “We are in the midst of a rupture, not a transition.”

New trading coalitions will have to be engineered, in our view. We are seeing this in Asia: China’s exports to the US have shrunk considerably in the past year⁹. According to the International Monetary Fund, more than half of Asian trade doesn’t leave the continent¹⁰, with governments recognising the need for greater integration.  

Smaller companies can adapt to change 

We think that one of the historical reasons for the small-cap premium is that smaller companies tend to be more adaptive: radical change demands flexibility and a willingness to innovate. Smaller companies also have more room to grow – it’s easier for a $15bn company to double in size than a $150bn one.

But being smaller doesn’t necessarily mean being leaner and faster. The dispersion of returns in the small-cap arena is much greater than among large caps¹¹.

The challenge is to identify the winners – tomorrow’s large-cap companies. And here lies another opportunity. These companies are subject to much less analyst coverage and more market inefficiency. This means that, if you have the process and the skills, there is greater opportunity to unearth good companies at attractive valuations.

Is small-cap underperformance just a blip?

We are at a point where I suspect people are starting to doubt whether the small-cap premium still works, after an extended period of relative underperformance. The question is: is this a permanent feature or a blip – a blip that has lasted a long time? My belief is that it is the latter.  

I believe that if you are disciplined about the sorts of companies you are looking for – those with depressed share prices but attractive growth prospects – then you can deliver good long-term outcomes.  

Investing now may seem counter-intuitive, but if you think the US’s dominance of the global stockmarket has peaked, that the huge amounts of capital the mega caps are throwing at artificial intelligence risk tarnishing their profitability, and that investors’ portfolios are too concentrated, then global small caps may represent an attractive diversification play.