Four reasons to buy this overlooked group of stocks early in 2026

MW Four reasons to buy this overlooked group of stocks early in 2026

By Philip van Doorn

The stars ahave lined up for small-capitalization stocks, this investment manager says

Small-cap companies in the U.S. are expected by analysts to increase profits much more quickly than larger companies as they see the greatest benefits from lower borrowing rates and tax breaks.

Investors might be well served by increasing their exposure to small-capitalization stocks right now, for several reasons outlined by Matt Bartolini, the global head of research strategists at State Street Investment Management.

More than three years into a bull market, you have probably seen warnings about high valuations for large-cap stocks, especially the Magnificent Seven (Nvidia (NVDA), Apple $(AAPL)$, Microsoft $(MSFT)$, Alphabet $(GOOGL)$, Amazon.com (AMZN), Meta Platforms (META) and Tesla (TSLA)), which together make up 29.3% of the SPDR S&P 500 ETF SPY.

The top 10 holdings of the S&P 500 index SPX make up 40.3% of the U.S. large-cap benchmark index, which is weighted by the companies' market caps. According to data going back to 1972 compiled by Ned Davis Research, this is close to the peak concentration for the index. The highest concentration for the top 10 stocks was 41.4% at the end of October.

So your S&P 500 ETF has been an excellent investment with low expenses. But it may be more concentrated than you had expected it to be. And that makes the case for index-fund investors to diversify further by adding exposure to smaller companies to their portfolios.

During an interview with MarketWatch, Bartolini gave four reasons the time was right to make that move.

Low valuation relative to large-cap stocks

Let's take a look at weighted forward price/earnings ratios for three S&P indexes, with comparisons to average valuations over the past five and 10 years. The table also includes five-year total returns, with dividends reinvested. The forward P/E ratios are based on Tuesday's closing prices and average earnings-per-share estimates for the next 12 months among analysts polled by FactSet. You may need to scroll the table or flip your screen to landscape to see all of the data.

   Index                 Forward P/E  Forward P/E to 5-year average  Forward P/E to 10-year average  5-year return 
   S&P 500                      22.5                           111%                            118%            97% 
   S&P MidCap 400               16.6                           105%                            102%            55% 
   S&P Small Cap 600            15.5                           100%                             96%            39% 
                                                                                                   Source: FactSet 

The S&P Small Cap 600 Index SML has the lowest forward P/E of the three indexes. It trades right at its five-year average forward P/E and below its 10-year average valuation. The S&P 500 and S&P MidCap 400 Index MID trade at premiums to the averages, with the S&P 500 trading at 118% of its average 10-year valuation.

Now let's show how the S&P Small Cap 600 Index's valuation relative to that of the S&P 500 has moved:

The S&P Small Cap 600 Index's forward P/E valuation relative to that of the S&P 500 is near a two-decade low.

Bartolini called this "the largest valuation discount in 20 years" for the small-cap group.

Lower interest rates will now bear fruit, especially for small-cap companies

The Federal Open Market Committee began cutting its target range for the federal-funds rate in September 2024, after which there were five more rate cuts through the end of 2025.

"It usually takes 18 months for monetary actions to filter into the real economy. We don't know what the Fed will do next, but we already have lower borrowing costs," Bartolini said.

With a concurrent increase in the money supply, the lower interest rates for corporate borrowers "should be a benefit to the underlying growth fundamentals," he said.

Advantages to corporate borrowers from the One Big Beautiful Bill

President Trump signed the One Big Beautiful Bill Act in July. The legislation includes income-tax breaks that may spur economic growth as people receive larger tax refunds from the Internal Revenue Service this year than they received last year.

Bartolini dug into some details that may be especially helpful to small-cap companies' bottom lines.

"Within the One Big Beautiful Bill Act, there are changes to the maximum amount of deductible interest expenses from 30% of EBIT to 30% of EBITDA," he said. EBIT stands for earnings before interest and taxes. EBITDA stands for earnings before interest, taxes, depreciation and amortization.

So the increase in the amount of interest expense that businesses can deduct from their taxable income "means more will flow through to earnings," Bartolini said. "Companies with high depreciation and amortization expenses, along with high interest expenses, are likely to receive the largest benefit."

Higher projected EPS growth rates for small-caps

All together, projections for continued economic growth in the U.S., lower interest rates and the new tax breaks have analysts expecting small-cap companies to see the largest advantages this year.

Analysts polled by FactSet project the S&P Small Cap 600 Index's weighted earnings per share for 2026 will increase by 19.1% from 2025, with EPS growth estimates of 17.3% for the S&P MidCap 400 Index and 13.6% for the S&P 500.

Small-cap index funds

The S&P Small Cap 600 Index is more selective than the Russell 2000 index RUT. S&P Dow Jones Indices includes four consecutive quarters of profitability among its criteria for initial inclusion in the S&P Small Cap 600.

The Russell 2000 is made up of the smallest 2000 companies in the Russell 3000 Index RUA, which itself is designed to capture 98% of the U.S. market for publicly traded common stocks. This means the Russell 2000 index includes hundreds of unprofitable companies, such as pre-revenue biotech companies.

A comparison of average annual total returns with reinvested dividends for various periods shows neither approach having a clear advantage:

   Index                 3-year avg. return  5-year avg. return  10-year avg. return  15-year avg. return 
   S&P Small Cap 600                   9.5%                6.8%                11.5%                10.6% 
   Russell 2000                       13.4%                5.9%                11.6%                 9.7% 
                                                                                          Source: FactSet 

The State Street SPDR Portfolio S&P 600 Small Cap ETF SPSM is an exchange-traded fund that tracks the S&P Small Cap 600 Index by holding all of its stocks. There are competing funds that track the index, such as the iShares Core S&P Small-Cap ETF IJR and the Vanguard S&P Small-Cap 600 ETF VSMSX.

Then there are index ETFs that take narrower approaches to the S&P Small Cap 600, such as the State Street SPDR S&P 600 Small Cap Value ETF XSD and the State Street SPDR S&P 600 Small Cap Growth ETF SLYG. There are also factor-based approaches that select stocks from within the index. An example is the Invesco S&P SmallCap Momentum ETF XSMO.

ETFs tracking the Russell 2000 index include the iShares Russell 2000 ETF IWO and the Vanguard Russell 2000 ETF VTWG.

There are many index funds out there. The broad index ETFs tend to have very low annual expenses. You will pay higher fees for factor ETFs that track subsets of the indexes, but some of these may fit your investment objectives.

Don't miss: This ETF from a 106-year-old firm has crushed rivals while avoiding 'Magnificent Seven' stocks

-Philip van Doorn

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January 14, 2026 08:02 ET (13:02 GMT)

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