Small-cap earnings recovery gathers steam, valuations still attractive: BofA

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Bank of America Securities says profit growth is finally broadening to small-cap stocks, with earnings revisions turning sharply positive after years of underperformance.

“Last month, the Russell 2000's 3% price return was entirely driven by positive EPS revisions—the forward P/E was essentially flat at 16.2 times, while the implied EPS change was the most positive since mid-2022,” wrote Jill Carey Hall, equity and quant strategist at BofA Securities, in an Oct. 3 report.

Performance earlier this year had been driven more by multiple expansion, but “small caps saw profits growth inflect positively in 2Q and both EPS and sales revision ratios have turned positive,” she said.

The relative earnings outlook for small versus large caps has improved since July after a two-year downtrend. Consensus now expects small-cap profit growth to outpace large caps beginning in the fourth quarter and continuing through 2026. Carey Hall said the team will be watching revisions, corporate guidance, tariff impacts and macroeconomic indicators to determine whether “the profits recovery is here to stay; we remain constructive on small caps for now.”

VALUATIONS FAVOR SMALL CAPS

Small caps remain the cheapest equity segment relative to long-term history. They currently trade about 7% above their long-run average, compared with mid-caps at 25% and large caps at 44% above average. Mega-cap valuations are even more stretched, exceeding 50% above average.

At current levels, small caps trade at a roughly 30% discount to large caps -- 0.72 times relative P/E versus a historical average of 0.99 times.

“Today's P/Es imply approximately 8% annualized price returns for the Russell 2000 over the next decade versus less than 1% a year for the Russell 1000,” Carey Hall said, while cautioning that the magnitude of outperformance may be narrower than history suggests given changes in index composition, leverage, and quality.

Meanwhile, the relative P/E between mid- and mega-caps has compressed to its lowest level in 25 years, strengthening BofA’s call for mid-caps over mega-caps.

VALUE OVER GROWTH

Within small caps, valuations continue to favor Value. The relative P/E for small-cap Growth versus Value is now 22% above its average, and Growth also screens expensive on other valuation metrics. With earnings growth broadening, Fed cuts on the horizon, and the U.S. economy shifting toward a “Recovery” regime, Carey Hall said BofA continues to recommend Value over Growth. Elevated Treasury yields also pose a risk to Growth stocks, particularly those with weaker earnings profiles.

SECTOR VIEWS

Financials remain BofA’s top-ranked sector across small and mid caps, supported by relative valuations, earnings revisions, and favorable analyst ratings. Technology also ranks highly given strong momentum and sentiment, though valuations are stretched. Health care continues to screen poorly across both segments, while Materials is the weakest sector in small caps and Consumer Discretionary fares worst in mid-caps, according to the report.

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