After years of underperformance relative to their large-cap peers, U.S. small-cap stocks appear poised for a resurgence. Historically known for their higher returns over the long term, small caps have struggled in recent years due to macroeconomic pressures, a lack of initial public offerings (IPOs), and the dominance of mega-cap technology companies. However, changing economic dynamics, attractive valuations, and supportive policy shifts suggest the tides may be turning.

The Russell 2000 Index’s recent performance seems to support the idea of a small-cap comeback. The iShares Russell 2000 Index ETF (NYSE: IWM) is currently up nearly 20% YTD and is reaching levels not seen since 2021.

Interest Rate Cuts: A Boost for Small-Caps

One of the most significant tailwinds for small caps in 2025 is the Federal Reserve’s pivot toward monetary easing. The Fed’s decision to lower interest rates has historically benefited small-cap companies, which often have higher exposure to floating-rate debt. As borrowing costs decrease, these firms are better positioned to invest in growth opportunities, improve margins, and participate in increased merger and acquisition (M&A) activity.

Lower rates also bolster management confidence and reduce the cost of capital, creating a favorable environment for expansion. Recent data shows that small caps, as represented by the Russell 2000 Index, have already started to respond positively to rate cuts, outperforming during periods of dovish monetary policy.

“Small caps are going to become more in favor in 2025,” VettaFi’s Todd Rosenbluth told CNBC’s “ETF Edge” recently. “They started to perk up since the election and heading into the election as interest rates have been coming down.”

Small-Caps Valuations Remain Attractive

Small-cap valuations are another compelling reason for optimism. Price-to-earnings (P/E) ratios for small caps are currently near their historical averages, but relative to large caps, they are trading at an 11% discount. This valuation gap, combined with analysts’ projections of robust earnings growth—15% in 2024 and over 30% annually through 2026—suggests significant upside potential.

Earnings growth is expected to drive the next leg of gains for small-cap stocks. With many companies positioned to benefit from economic expansion, reshoring efforts, and infrastructure investments, small caps may see earnings accelerate faster than their large-cap counterparts. If these projections hold, the valuation discount could narrow, delivering outsized returns for small-cap investors.

According to BNP Paribas analysts: “We expect earnings to drive the next leg higher for small-cap share prices. Analysts are looking for robust earnings growth: 15% this year, and by over 30% in 2025 and 2026. That is ahead of the long run rate of 13% growth.”

Reshoring and Infrastructure Investment

A structural shift in supply chains is also creating opportunities for smaller U.S. companies. Over the past two decades, U.S. firms outsourced production to lower-cost countries, but recent geopolitical tensions, supply chain disruptions, and federal incentives like the CHIPS Act and Infrastructure Investment and Jobs Act are encouraging businesses to bring manufacturing back to the U.S.

Small-cap companies, which tend to be more closely tied to domestic markets, are well-positioned to benefit from this trend. Increased capital expenditure on reshoring initiatives, AI-driven data centers, and infrastructure development provides a multi-year growth runway for smaller firms.

M&A Activity Picking Up

Merger and acquisition activity is another potential catalyst for small caps. As interest rates decline and economic uncertainty diminishes, strategic buyers are likely to resume deal-making. This trend could unlock value for small-cap investors, particularly in sectors like technology, healthcare, and industrials, where innovation and disruption are driving demand.

Asure Software: A Small-Cap Standout

One small-cap worth keeping an eye on is Asure Software (NASDAQ: ASUR), which currently has a current market cap of $256 million. During the company’s recent third quarter 2024 period, Asure reported revenue (excluding ERTC) of $29.2 million, which was up 20% year-over-year (y/y). Recurring revenue came in at $28.6 million, also up 20% y/y, and accounted for 98% of total revenues. Asure’s adjusted EBITDA came in at $5.4 million for the period.

The Austin-based HCM provider saw a robust surge in new bookings by 141% y/y and backlog growth of 250% y/y. The results come as management continues to see strong demand for its products, particularly its Payroll Tax Management solution. Asure is also currently engaged in testing a beta version of its new AI agent chatbot and preparing to launch its new financial services product, AsurePay.

Asure’s core HCM business has shown consistent double-digit revenue growth, expanding by 16% y/y in 2022 and 19% y/y in 2023. For 2024, management projects double-digit growth once again, excluding one-time revenues from the Employee Retention Tax Credit (ERTC). Looking ahead to the full year 2024, Asure’s management estimates revenue to come between $119 million to $121 million, representing growth of around 20% y/y. Adjusted EBITDA margins are estimated between 18% and 19%.

Looking further ahead, full-year 2025 estimates project continued growth on both the top and bottom lines, with total revenue expected to land between $134 million and $138 million and adjusted EBITDA margins forecasted between 23% and 24%. Despite its impressive growth trajectory, Asure trades at a discount relative to peers, with an enterprise value-to-revenue multiple of just 1.3x compared to a peer average of 5.7x. If Asure achieves a comparable valuation, its share price could experience additional upside.

Another area of bullish support for Asure is the fact that software stocks have continued to outperform semiconductors. We covered this phenomenon in September 2024, but the trend has extended since the 2024 election. As of this writing, the iShares Expanded Tech-Software ETF (NYSE: IGV) is up 30% YTD in 2024, compared to the iShares Semiconductor ETF’s (NYSE: SOXX) YTD gains of 14.50%. 

Conclusion

As we head into 2025, small-cap stocks are positioned to capitalize on a confluence of favorable factors that have the potential to reignite their long-term outperformance. The Federal Reserve’s shift toward monetary easing provides a significant tailwind, lowering borrowing costs and boosting business confidence for smaller companies. At the same time, compelling valuations and robust earnings growth forecasts underscore the value proposition for investors willing to navigate this dynamic segment of the market. 

Structural trends such as reshoring, infrastructure investment, and an anticipated uptick in merger and acquisition activity further enhance the growth potential for U.S. small caps, which are closely tied to domestic economic cycles. Companies like Asure Software exemplify the resilience and promise within the small-cap universe, demonstrating how innovation, recurring revenue models, and strong operational performance can translate into meaningful shareholder value. For investors seeking opportunities beyond the crowded large-cap space, small caps offer an intriguing blend of value and growth, with 2025 shaping up to be a year of renewed focus and opportunity in this often-overlooked market segment.

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