Developed International Small-Cap Stocks (Unlike Their US Counterparts) Are Outperforming This Year
By James Picerno | The Milwaukee Company
US small-cap stocks have lagged US large-caps in recent years
International small-cap stocks in developed markets are currently outperforming international large caps
International small caps look positioned for continued strength due to favorable valuations and recent momentum.
The investment case for small-cap stocks has caught a lot of grief in recent years, and for an obvious reason: performance has been lackluster, particularly when measured against large-cap shares. No one anticipates consistent outperformance, but the motivating thesis for owning small caps is that this slice of the equities market is expected to outperform over the medium to long term. That was mostly true in the years following the landmark 1981 paper that found a “size effect” in stocks from 1936 through 1975. But the small-cap premium has faded.
For example, the iShares Core S&P Small-Cap ETF (IJR) has trailed its large-cap counterpart (SPY) by a hefty margin over the trailing 5- and 10-year periods, according to Morningstar.com.
The chart below reminds that small caps had been posting strong performance over large caps. But the leadership topped out during the 2012-2019 period, and since then small caps have fallen behind large caps with a fair amount regularity, according to a ratio for a pair of ETFs that proxy for the two markets.
The weaker performance in small caps can be explained by several factors, but perhaps the most compelling is the rise of big tech in recent history. As the largest tech firms – think Apple, Microsoft, Google, etc. – have increased their dominance, their market leadership positions have become increasingly profitable. Investors, in turn, have rewarded the so-called Magnificent 7 stocks with higher valuations and prices.
Add in cost-intensive efforts related to artificial intelligence (AI) into the mix and big tech’s advantages become even more striking. In turn, smaller firms are having a tougher time competing in the tech-fueled new world order.
Is the small-cap effect dead? Unclear, but it has certainly turned dormant lately. Generalizing about small-caps, however, can overlook opportunity. For example, the small-cap premia look more durable in foreign markets. Small-cap ex-US performance in developed markets (ISCF) has a stronger record of posting outperformance vs. an international large and mid-cap benchmark (EFA), compared with the US equivalent, as the next chart using ETF proxies suggests. Part of the reason may be that Magnificent 7 effect in the US has no counterpart (or at least nothing directly comparable) in foreign developed markets.
Year to date, developed-world small-cap is showing renewed leadership over its large-cap counterparts. ICSF in 2025 is up 18.5%, a moderate premium relative to EFA’s 17.2% increase, as of June 18.
The international small-cap premium may have further room to run. For starters, international equities generally have only recently started to outperform US stocks after a long period of American leadership. If this marks a secular shift, foreign equities could be poised for several years of superior results – a scenario that, presumably, would fuel the ongoing strength in international small caps over their large-cap brethren.
Second, small-cap valuations are relatively low, which implies higher expected returns. ICSF’s trailing price-earnings ratio is roughly 12.0, according to Morninstar.com. That’s moderately below the 14.8 p/e for developed market stocks (EFA) and the 14.5 p/e for US small caps (IJR). The discount is far more dramatic compared with the lofty 22.3 p/e for US big-caps (SPY).
Recent price momentum and valuation, in other words, favor international small caps. That’s no guarantee, but the comparisons suggest that a tailwind could continue to blow in favor of the small-cap effect ex-US.