Beyond Mega-Cap Tech, Small Caps Flex Their Fundamentals

SPEAKER_1 (0:00)

Let's discuss the case for small caps, and welcome our next guest, Matt Barry, who's the head of ETFs over at Touchstone Investments. Good afternoon to you, Matt.

All right, when we talk about the case for small caps, I mean, you only have to look at the Russell 2000, I suppose, in this outperformance we've seen, kind of year to date, it feels like a quiet achiever of sorts. What has been driving that?

Matt Barry (0:23)

Yeah, so fundamentals are really strong in the small cap space. Looking at earnings growth, revenue growth, taking a step back and looking at the broader market, it's been so driven by a handful of very narrow mega cap stocks over the past one to two decades, that we're seeing a lot of investors try to improve diversification by looking abroad. And the stronger fundamentals and small cap space have been on the radar for a couple of years. It's been nice to see in 2026, that change from being on the radar with stronger fundamentals to actually being reflected in the price chart so far year to date.

SPEAKER_3 (0:56)

And as we look at this broadening out, that we keep talking about in the markets, beyond these mega cap tech names, how important is that to the small cap thesis? And as you look at small caps, is this a durable trend or a more short-term rotation?

Matt Barry (1:12)

That is the big question, the durability of it. So we're seeing it year to date. Earnings are strong, revenue growth is strong. Will it continue?

And I think it is more than just a short-term rotation, the names at the top end of the cap spectrum, really strong fundamentals there as well, but it's more expensive valuations. And so I think there is some durability to this theme, particularly for investors to make sure they're not abandoning the mega cap names, but they are ensuring their portfolios have adequate diversification going forward through looking at names like international, their fixed income, and importantly, small cap investors.

SPEAKER_1 (1:46)

What is the biggest risk right now? Because as we know, small caps often benefit from the tailwinds, from peak rate cycles. I'm just wondering, we've flipped from talking about pricing in rate cuts to now hikes and the potential for more than just one and done here. What does that mean going forward then for the trade?

Matt Barry (2:11)

There definitely are still risks on the table. Interest rate risk is a key one of those that could significantly impact small cap stocks. They have a lot of operating leverage, that's a key one to keep an eye on.

SPEAKER_3 (2:22)

As we look at that then, how are you also looking at the geopolitical risks here? Because we see small caps generally tend to be more responsive to these and we certainly still have them on the table here. How does that come into play?

Matt Barry (2:35)

That absolutely comes into play as well. Geopolitical risk is still there in addition to the interest rate risk. That's why small cap stocks have a role to play in the portfolio. If you look at their overall role in the market, it's decreased from about 8 percent of the US market to about 4 percent.

So relatively small risk, but it's a different way to get access to a different asset class to balance that out while being cognizant of those risks that remain.

SPEAKER_1 (3:00)

And what areas of the small cap trade should investors be looking at right now? Because I'm just wondering if you're looking at, for instance, Energy. We were just speaking about a very diversified downstream company that is Dell at US Holdings that has performed remarkably well this year. It's up in triple digits year to date. I'm just wondering if there is anything outside of Energy where you would be looking right now.

Matt Barry (3:26)

Yeah, industrials is one sector that does come up a lot. When you look at the AI trade and how you play that through mega cap stocks, you're still getting AI exposure, but second level effects when you go down cap because there is a lot of infrastructure through other sectors besides tech that needs to be built out to support that trade.

SPEAKER_3 (3:46)

And another thing that you highlighted here is that because small caps have generally less analyst coverage, there's a greater dispersion between the winners and losers. Does that create a bigger opportunity here for active managers and people who are really willing to do the work to research these more stock specific names?

Matt Barry (4:06)

Yeah, it absolutely does. There are so many stocks in that universe and for the pool of stocks, there's generally less analyst coverage and bigger dispersion amongst names when you compare the winners to the losers.