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Are Small Cap Returns Sustainable?

At first glance, headline returns for small-cap companies as represented by the Russell 2000 Index (up 12.81%) in 2025 looked healthy. However, when peering beneath the hood, it was clear that business fundamentals took a backseat to investor speculation amidst a post-Liberation Day rally for U.S. equity markets.

In a recent publication from JP Morgan Asset Management1, they estimated that 39% of the companies comprising the Russell 2000 Index were unprofitable in the most recently available quarter. These non-earners, along with those with the lowest return on equity (ROE) and companies with the highest debt to capital ratios, were the relative outperformance winners among Russell 2000 constituents in 20252 . The largest cohort of non-earning and outlier companies in the Russell 2000 Index were also concentrated amongst the smallest companies in the benchmark. Less than 40% of these names are expected to be profitable over the next twelve months3 . To summarize so far, winners in the Russell 2000 Index last year were small, unprofitable, low-returning businesses with stretched balance sheets. Was this speculation driven by fear of missing out (FOMO) or investment? To answer that question, we dug deeper into our investable universe.

Of the roughly 1450 U.S. based companies (excluding Real Estate Investment Trusts (REITs)) in our investable universe with market capitalizations between $400M and $5B, 39% had negative or no earnings over the prior 12 months. Additionally, 29% of these companies were expected to have negative or no earnings over the next fiscal year4. Of the 39% of companies with negative or no earnings, 219 of these outperformed the Russell 2000 in 2025. Over half of the outperformers were concentrated in the Health Care sector and specifically in the Biotechnology industry group. Biotechnology is by nature a speculative industry, due to the difficulties related to drug discovery and eventual successful human trials. According to an article in Nature magazine5 , only about 10—15% of compounds that enter human clinical trials receive regulatory approval as a drug. The rewards can be tremendous for early backers of these companies, but many fail before ever becoming available to public investors. When looking at these Biotechnology outperformers in 2025, there were several conclusions that were not surprising:

1. 6/85 (7%) had a positive ROE
2. 4/85 (4.7%) had a positive Return on Invested Capital (ROIC)
3. 4/85 (4.7%) had positive trailing twelve months Free Cash Flow (FCF)
4. 1/85 (1.1%) had positive FCF during the last fiscal year (FY)

Perhaps much of this speculation in 2025 was driven by the potential positive impact of artificial intelligence (AI) on the drug discovery process going forward. However, Biotechnology has been at the forefront of technology, including AI and genome sequencing for years, and payoffs tend to be much longer term. Perhaps FOMO led to speculative index buying which lifted all boats, even those that were relatively illiquid.

The speculative impact of indiscriminate buying was much less in the other popular small cap benchmark, the S&P 600 Index, which returned only 6.02% in 2025. Non-earners are a much smaller portion of this benchmark as it is constructed by an investment committee that requires positive earnings for both the most recent quarter, and the sum of four consecutive quarters for inclusion. Biotechnology outperformers numbered only 7 companies in this index over the past year for comparison.

It remains unclear when investing replaces speculation as it relates to smaller companies and winners and losers within benchmarks. There has been much discussion among investors related to benchmark concentrations for large cap companies, but the impact is much less in the small cap indexes. Small-cap detractors have cited lofty valuations, as the headline forward price to earnings (P/E) multiple on the Russell 2000 Index of 23x at year-end 2025 is greater than the multiple on the S&P 500 index. Removing the non-earners and outliers from the Russell 2000 reduces that 23x multiple to a more reasonable 15.8x6 . This is a 29% discount to the forward 12-Month P/E ratio of the S&P 500 Index which was 22.2x at year end7 . In our view, speculation can sustain returns for a while, but not indefinitely.
Eventually, businesses that have attractive valuations, generate free cash flow, have strong returns on invested capital, grow earnings, and maintain a solid capital structure are recognized by the marketplace. We focus our efforts on owning businesses with these and other positive attributes and remain long-term investors rather than speculators.

1 Kelly, et al. JP Morgan Asset Management. Guide To The Markets, Page 13, January 2026.
2Subramanian, et al. Bank of America Merrill Lynch, US Performance Monitor, January 2026.
3 Carey Hall, et al. Bank of America Merrill Lynch, US Small/Mid Cap Valuations, January 2026.
4Source: FactSet.
5Mullard A. Parsing clinical success rates. Nature Reviews Drug Discovery 15, 447 (2016).
6 Carey Hall, et al. Bank Of America Merrill Lynch, US Small/Mid Cap Valuations, January 2026.
7Butters, John. FactSet Earnings Insight, Jan 9, 2026