Out of favour but full of potential: Why cyclical small-caps deserve a second look

Turning points rarely come with headlines. They build quietly. For most of the past year, momentum has dominated global equity markets. In the large-cap universe, a handful of ‘mega caps’ have driven returns on the back of a strong belief in the Artificial Intelligence opportunity. Within the small-cap universe, 10% of the industry groups related to the same dominant themes have driven 100% of the index return year-to-date.

As a result, smaller companies tied to the broader economy have been left behind in this shift (Figure 1 and 2). The dominant momentum factor has further amplified this extreme market positioning. There is a discomfort with owning out-of-favour names when these market shifts occur, though the material asymmetry in the risk-reward opportunity is often the signal long-term investors seek.