Miles Lewis: We believe that both small-cap quality and value are poised for meaningful rebounds in 2026. 2025’s returns, particularly since the April lows, have been driven primarily by lower quality, speculative stocks and just about anything that is an obvious beneficiary of the artificial intelligence (AI) boom, even those companies with no current revenues, such as one company with a US$15 billion market value—and no revenue! Low quality cycles tend to last about 12 months on average, suggesting that a regime shift in 2026 is likely.
Furthermore, more “traditional” businesses models—those that have healthy margins, generate free cash flow, grow modestly, and have strong, self-funding balance sheets that also trade at attractive valuations (i.e., quality value stocks) should recapture the interest of investors as the junk rally fizzles. Fitting this narrative, we see businesses in sectors such as consumer staples and in industries like packaging, business services, and insurance doing well. We also see the AI theme broadening from (mostly) capital expenditure (capex) related models to companies that can commercialize AI applications to grow their businesses and/or companies—which will see margin improvement by leveraging AI tools.
We also see one development that will surprise investors in 2026: Small-caps will likely outperform! The long, dark winter of small-cap underperformance has been exhaustively documented and is well understood. We think 2026 could be the year that small-caps reassert themselves.
Importantly, we see a path to this outperformance in at least two ways: In one scenario, the economy will have continued and accelerating strength in 2026, in part driven by stimulus coming from Washington that could benefit both businesses and consumers, particularly those in the lower half of the income distribution. Should this occur, we’d likely see more widespread economic growth, benefiting a broader array of industries from banks (thanks to loan growth and healthy credit) to select areas in industrials (due to onshoring and solid general growth) and consumer discretionary. The earnings growth of small-caps, already expected to beat large-caps in 2026, would likely accelerate further. AI would no longer be the only growth game in town! In this scenario, it’s likely we see a broadening of US equity market returns, in stark contrast to the unprecedented narrow market leadership of the last few years. Historically, when this happens, small-caps have beaten large-caps most of the time and have done so by healthy margins.
The other scenario, which is less rosy, is that the AI bubble begins to deflate – or worse, bursts. In fact, we could see the ‘Mag 7’ become the ‘Lag 7’. If this were to happen, we’re likely to see a period of poor performance across all style and market cap spectrums. But it’s also quite plausible that small-caps, having lagged meaningfully already and sporting far less demanding valuations, fall less, perhaps much less. While that may sound farfetched, this is exactly what happened when the tech bubble burst in 2000.
Based on our conversations with CEOs and CFOs across a variety of industries, the former scenario seems more likely, and that’s our hope. But narratives, as well as fundamentals, can change quickly and unexpectedly at times of excess. We aim to be prepared to capitalize on opportunities in either scenario.
Chip Skinner: We are constructive on small cap growth stocks as we head into 2026, primarily due to the accommodative fiscal and monetary policies of the current administration. The speculative activity that characterized the early part of the fourth quarter has since faded, and we are encouraged by a broadening in positive earnings revisions as macro headwinds continue to ease.
A key—and in our view underappreciated—tailwind entering 2026 is the acceleration of fiscal spending tied to onshoring initiatives, industrial policy, infrastructure, and energy-related programs. Coupled with an expected Federal Reserve (Fed) easing cycle over the coming months, these forces should support meaningful economic expansion and create a favorable backdrop for small-cap growth companies. Many of these businesses have spent the past few years improving cost structures and sharpening execution, positioning them to deliver strong operating leverage as demand reaccelerates in 2026.
We also expect the consumer to remain resilient, with stable employment data trends contradicting some of the more negative headline narratives. Valuations for small-caps remain discounted relative to their large-cap counterparts, and earnings expectations are still conservative in our view, leaving room for positive revision momentum. While we are constructive on the year ahead, we recognize that the benefits of aggressive fiscal spending and lower rates may carry longer-term trade-offs in the form of renewed inflation pressures and widening budget deficits.
Kavitha Venkatraman: Regardless of one’s politics, we think the “Big Beautiful Bill” will prove highly stimulative to small-cap companies and to lower-end consumers in 2026. The 100% bonus depreciation for certain capital investments and immediate expensing of R&D spend—as opposed to it being amortized over several years—are both attractive features of the bill, particularly for smaller companies. These new rules incentivize businesses to redirect their saved tax dollars to productive uses, which is powerful for smaller businesses.
Based on our recent conversations with company management teams, we believe spending will pick up in 2026 and drive economic growth. We consequently expect a positive inflection in hiring by small businesses, which should help employment-related stocks. Further, we anticipate that this investment cycle will drive continued robust demand for power.
In 2026, lower-income consumers—who’ve been very challenged over the last couple of years—could receive higher tax refunds (they’re expected to be 44% higher than 2025’s) and may pay lower taxes, thanks to no federal taxes on tips, expanded deductions, and family credits embedded in the federal budget. These features should relieve some of the inflationary pressure that these consumers have been facing and have a positive impact on several areas in the consumer discretionary sector, such as retail and travel & leisure etc. Many small-cap companies in these industries currently have attractively cheap valuations, and we have been increasing our exposure.
Steven McBoyle: I expect US small-cap industrials—particularly precision manufacturers, engineered components suppliers, and value-added industrial technology providers—to perform well in 2026. We are already seeing increased activity in select areas, such as improving order books across specialty manufacturing, an improved aerospace supply chain, and growth in automation/controls applications. Against this favorable backdrop, operating leverage appears poised to expand as supply chains normalize and freight and input costs stabilize.
Equally important, many small-cap companies in these areas should continue to benefit from a multi-year US manufacturing and reshoring cycle, supported by elevated industrial capex, fiscal incentives, supply-chain re-localization, and persistent labor scarcity—while this last development has been accelerating the adoption of automation and higher-productivity capital equipment. This combination of cyclical recovery and secular tailwinds supports my constructive view for high-quality small-cap industrial franchises.
That said, the AI capital cycle introduces meaningful uncertainty across several sectors—including Industrials. Recent reports out of China, for example, highlight a dynamic that is underappreciated in the US’s AI narrative: data center utilization rates as low as 20%-30%, idle GPU (Graphics Processing Units) capacity, and government-led efforts to repurpose unused compute power. As China accounts for roughly one-quarter of global data center construction, this suggests that parts of the global compute build-out may already be encountering early signs of overcapacity—an outcome at odds with the prevailing US market consensus of persistent chip and compute shortages.
While I have concerns about the durability of the current AI “dream state”—technology revolutions often follow classic capital-cycle patterns that end in creative destruction—the broader US industrial capex cycle remains intact. High-quality industrial small-caps with strong balance sheets, pricing power, and recurring or aftermarket-driven revenue models should remain among the long-term beneficiaries of reshoring, automation, and ongoing productivity investment. In that context, I believe the quality industrial businesses are well positioned for growth in 2026, even amid evolving AI-related risks.
Francis Gannon: The Russell 2000 Index is up more than 45% since the market’s low on 4/8/25, a span that has also seen small-caps beat their large-cap counterparts. In light of this dynamic performance, it may seem counterintuitive that my outlook has not shifted much since the end of the second quarter. Even with these robust results, however, small-cap stocks as a group remain far more attractively valued than their large- and mega-cap peers, as measured by our preferred index valuation metric, EV/EBIT—enterprise value over earnings before interest & taxes. The same holds true for micro-caps—which have rebounded even more impressively since early April, up more than 68%—relative to large-cap stocks.
Yet almost every day you can hear someone insisting that ‘the market’ is overvalued. It’s important to keep in mind that when these market observers talk about stocks being overvalued—or inching close to bubble territory—they are almost always looking at the S&P 500 or the Nasdaq Composite, each of which is heavily skewed toward mega-cap stocks, particularly the ‘Magnificent 7.’ In fact, I agree that valuations appear stretched within the large-cap category as a whole—but investors should be aware that small-caps have more than enough room to run before getting close to the valuations that large-caps have been trading at for the last two-plus years.
But the argument in favor of small-caps is not based on valuation alone. I’ve always subscribed to the adage that psychology runs the market in the short run, but earnings run it in the long run. And while 3Q25 earnings across asset classes were generally positive, with many companies handily beating estimates, smaller companies generally fared better in terms of earnings growth. Even better, the research we’ve seen forecasts accelerated earnings growth for small-cap stocks in 2026. The recent Fed cuts have helped, while additional catalysts include the likelihood of a healthy capex cycle, possible tariff relief, and reshoring, along with the benefits accruing to those small-cap companies that are providing the ‘picks & shovels’ for numerous AI-related projects.
So, while a fair amount of uncertainty exists in the US economy and on the geopolitical front, our investment teams are highly confident that the small-cap category can sustain, if not build on, its nascent market leadership. Finally, I would remind investors that the opportunity still exists to build one’s small-cap allocation at attractive valuations. We continue to see the current period as an opportune time to invest in select small-caps for the long run.
Definitions
The Russell 2000 Index is an index of domestic small-cap stocks that measures the performance of the 2,000 smallest publicly traded US companies in the Russell 3000 Index.
The Nasdaq Composite is a stock market index that includes almost all stocks listed on the Nasdaq stock exchange.
Magnificent 7 data refers to the following set of stocks: Microsoft (MSFT), Amazon (AMZN), Meta (META), Apple (AAPL), Google parent Alphabet (GOOGL), Nvidia (NVDA), and Tesla (TSLA). There is no assurance that any estimate, forecast or projection will be realized.
The Standard and Poor's 500 (S&P 500) is a stock market index tracking the stock performance of 500 leading companies listed on stock exchanges in the United States.
Enterprise value (EV) refers to the entire value of a company after taking into account both holders of debt and equity.
The EV/EBIT multiple is the ratio between enterprise value (EV) and earnings before interest and taxes (EBIT).
The One Big Beautiful Bill Act, or the Big Beautiful Bill, is a US federal statute passed by the 119th United States Congress containing tax and spending policies that form the core of President Donald Trump's second-term agenda. The bill was signed into law by President Trump on July 4, 2025.
Capital expenditure (capex) refers to investment spending in long-term assets (fixed assets). These expenditures include new buildings, machinery, and other equipment needed for an organization's day-to-day operations. Most companies use capex financing to fund their long-term investments.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
Equity securities are subject to price fluctuation and possible loss of principal.
Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
Small- and mid-cap stocks involve greater risks and volatility than large-cap stocks. Large-capitalization companies may fall out of favor with investors based on market and economic conditions.
The investment style may become out of favor, which may have a negative impact on performance.
Active management does not ensure gains or protect against market declines.
The government’s participation in the economy is still high and, therefore, investments in China will be subject to larger regulatory risk levels compared to many other countries.
Any companies and/or case studies referenced herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio. Past performance does not guarantee future results.
Any data and figures quoted in this article sourced from Russell Investments, FactSet, Bloomberg and Reuters.
Important data provider notices and terms available at www.franklintempletondatasources.com. All data is subject to change.
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