Prediction: Small-Cap Stocks Will Outperform Large Caps Over the Next 3 Years. Here's Why.

Key Points

• Small-cap stocks have underperformed their large-cap counterparts for years.

• The valuation gap between small caps and large caps is the widest it’s been since the 1990s.

• A falling-rate environment could disproportionately benefit small caps over the next few years.

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Small-cap stocks have lagged large caps for years. (Investors divide stocks based on the size of their market cap.) Over the past 10 years, the total return of the S&P 500 large-cap benchmark index has been about 150 percentage points greater than the small-cap benchmark Russell 2000. There are large performance gaps over the past five-year and three-year periods as well, and so far in 2025, large caps are outperforming small caps with total returns of 8% and 1%, respectively.

As a result of this long-term outperformance, the valuation gap between large caps and small caps is the widest it has been since the late 1990s. The average S&P 500 component trades for a price-to-book ratio of 5.0, while the average P/B of Russell 2000 stocks is just 1.8.

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A falling-rate environment could help narrow the gap

There are a few reasons why I think small-cap stocks are an excellent investment opportunity over the next few years. For example, investor appetite for speculation seems to be increasing recently. IPOs, M&A, and even SPACs are making a strong comeback. And this favors investment in smaller companies.

However, the biggest reason I've been aggressively buying shares of the Vanguard Russell 2000 ETF (NASDAQ: VTWO) -- which invests in 2,000 stocks with a median market cap of $3 billion -- is because I believe we'll see interest rates fall significantly over the next three years, and small caps will be a big beneficiary.

For one thing, small caps tend to be more debt-reliant than large caps, and lower interest rates make borrowing costs cheaper. Plus, as risk-free investment opportunities (like Treasuries) fall, more money will flow into the stock market as investors look for better returns, and this also generally favors small caps.

Last but not least, the current regulatory-friendly environment could be a positive tailwind for all U.S. companies, but could be especially beneficial to smaller companies, removing roadblocks and allowing them to compete more effectively with their larger counterparts.

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Matt Frankel has positions in Vanguard Russell 2000 ETF. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.