Hunting for Big Winners in Small Caps

In this Q&A, Brandon Nelson, CFA, Senior Portfolio Manager, speaks to:

• Why he believes small caps have a lot more room to run.
• Niche opportunities that check the boxes for him as he seeks small cap winners.
• The outsized potential that microcaps may offer.

Q. Brandon, what makes small caps attractive in the current market?
A. A lot of investors worry that they missed the rally in small caps, but I see a small-cap bull market with more room to grow. It’s early innings, in my view. The average small-cap bull market has lasted an average of nearly three years, with cumulative gains of more than 130% for the Russell 2000 Index. We’re nowhere near that, and the valuations and growth opportunities of small caps are really attractive, in my view.

Even though small caps have tended to win over the long term, amazingly, they have lagged large caps for eight years in a row. Additionally, valuations look attractive, with data from Jefferies suggesting that small caps are in the 17^th percentile (inexpensive) of historic relative valuations compared to large caps.¹ While small caps are inexpensive, and we’ve seen plenty of small-cap stocks deliver strong results without the market rushing to small-cap stocks, we believe that earnings momentum may be a catalyst for investors in the future. I believe small caps are poised to see year-over-year earnings growth rapidly accelerate in 2025, with data from Jefferies pointing to an acceleration in the second quarter.

Small cap earnings growth poised to lead (year-over-year expected earnings growth %)

Past performance is no guarantee of future results. Source: Jefferies, “JEF’s SMID-CAP Strategy—Thoughts & Observations” February 6, 2025. Data as of January 29, 2025 using: FactSet; Standard & Poor's; Jefferies. Data shown are estimates (E).

But here’s where I need to make an important point—and one that surprises a lot of people.  We don’t need small caps to win for us to find winning small caps. Asset class strength like this is great to have, but it’s not what drives my optimism about the portfolios I’m managing. For me, small-cap asset class strength is the icing on the cake. What I’m most excited about is the return of a market where stock selection and fundamental momentum matter more—that’s what we saw in 2024, which set up very well for us.  

Q. Are there areas of the market where you believe the momentum is especially compelling?
A. There are several pockets of fundamental momentum in the economy, mostly within the technology, health care, and consumer discretionary sectors. We’ve found many exciting niche companies and idiosyncratic opportunities within these sectors.

Q. From a macro standpoint, what are the headwinds and tailwinds that could influence small-cap performance from here?
A. Small caps are perceived as being disproportionately interest-rate sensitive. So, for now, the main headwind is stubbornly high inflation, which is causing 10-year bond yields to stay somewhat elevated. This, in turn, is keeping a lid on valuations for the average small-cap stock. It’s important to remember, though, that not all small caps are heavily indebted, and active management can prove helpful in this regard.

Tailwinds include a low risk of recession—tight credit spreads are evidence of this—and high valuations for mega caps, which in turn are causing many investors to look for new, fresher themes—including in the small-cap and mid-cap space.

Q. To illustrate your process in action, tell us about some companies that “check the boxes” for you.
A. The core belief that drives our process is that fundamental momentum drives price momentum. I want to see companies with growth that checks two boxes—it needs to be sustainably fast and underestimated by the market.

One company that I really like is Rush Street Interactive (ticker: RSI). Rush Street operates online sports betting and online casino gambling, a mega trend in both US and international markets. Rush has exposure to niche markets within the industry. Our team believes Rush’s innovative technology positions it for sustainably fast growth, while a business mix tilted toward iGaming as opposed to online sports betting has favorable financial implications. Rush also has a savvy management team that knows how to run the business efficiently and manage expectations appropriately.

A second example is ADMA Biologics (ticker: ADMA). Founded by brothers named Adam and Matt, ADMA is a healthcare company providing plasma-based biologics to patients with severe immune deficiencies. Its products are life-changing, especially Asceniv, its largest and fastest-growing product. At this point, demand for Ascentiv far outstrips supply, and ADMA is adding capacity, creating a powerful, sustained growth profile. Additionally, management has a stellar track record of meeting and exceeding expectations.

Q. You’ve focused on small caps throughout your nearly 30-year career. What drives your passion for small-cap investing?
A. I want to find big winners for investors, and I believe small caps offer the most opportunities for doing that. Looking back nearly 100 years from 1928 through 2024, small caps have beaten large caps, mid caps, bonds, and real estate.¹ And, over the period from 2013 to 2023, small caps and micro caps were more likely to knock the cover off the ball versus large caps (see chart below). Of course, the past can’t predict the future, and not all companies can perform at this level. This is where our fundamental research comes into play.

Big winners disproportionately come from the small and micro buckets
10-Year 1000%+ Returners (2013-2023)

Past performance is no guarantee of future results. Source: Factset, Raymond James Research

Q. Tell us more about how you incorporate micro caps into the Calamos Timpani portfolios.
A. We see lots of “big winner” potential in the micro-cap space and believe that our focus on fundamentals gives us the insights we need about potential risks and opportunities. Because they are so inefficiently priced, micro caps have the highest probability of being “re-rated” higher. By that, I mean that through the process of strong company execution (i.e., displaying fundamental momentum) and getting discovered by new investors, micro caps are most likely to see their valuation multiples rise. Keep in mind, this re-rating process still has to be earned. That’s why stock picking is so critical.