For most of the past decade, investing in small-caps to outperform large-caps has been a losing effort. There have been periods, such as 2020, when this group has done well, but those have been the exception instead of the rule.
2026 is starting to look different. Investors are paying attention to valuations again. Small-cap earnings growth is finally accelerating. The iShares Russell 2000 ETF (IWM +0.16%) is beating the Vanguard S&P 500 ETF (VOO -0.25%) by roughly 9% year to date, and it's being driven by improving fundamentals.
That's not where I see the biggest opportunity. The Vanguard Small-Cap Value ETF (VBR +0.16%) looks like it has the most catching up to do. Here's the investment case.
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The valuation gap
Cheaper valuations don't necessarily translate into future outperformance. We've clearly seen that over the past few years. But investors have begun rotating into value stocks again as a possible signal that they believe the tech rally may be showing signs of peaking.
The small-cap value category is one of the best places to find pure value. The Vanguard Small-Cap Value ETF trades at a forward price-to-earnings (P/E) ratio of around 14, which compares favorably to the 20 multiple of the Vanguard S&P 500 ETF. With earnings growth expected to accelerate into the high double digits over the next year, the risk/reward trade-off is much improved.
NYSEMKT: VBR
Key Data Points
Earnings growth picking up
One of the primary factors that has led to small-caps' massive underperformance has been corporate earnings. A lot of companies were generating minimal growth while S&P 500 earnings continued to increase steadily post-COVID.
Thanks to the artificial intelligence (AI) boom, small-cap earnings growth is picking up again. It's expected to grow by 18% in 2026 and another 18% in 2027. The latter would be the first time small-cap earnings growth has beaten that of the S&P 500 in several years.
There's now a fundamental foundation in place for small-cap stocks to grow.
Small-cap value stocks are a buy
There is one potential risk to flag. A lot of small-cap value stocks are cheap for a reason. Many of them are still unprofitable. But the AI boom is improving overall balance sheet quality. The stocks that can get beaten down in an economic downturn are the same ones that can outperform as conditions are improving.
The current level of value combined with rising earnings growth rates means investors should consider the Vanguard Small-Cap Value ETF here. I think conditions are finally lining up for this group to break out from years of lagging performance.
