Latest / Stock Picking with Fexingo: Individual Equities, Research, and Building a Concentrated Portfolio / How Small-Cap Stocks Are Making a Quiet Comeback in 2026
Transcript
- Lucas: So the Russell 2000 is down 0.9 percent this week, and the S&P 500 is only off half a percent. On the surface that looks like just another week of large caps winning. Luna: But you're not buying that surface read, are you? Lucas: I'm not. Because if you dig into the internals, there's a pretty interesting divergence underneath. The Dow is actually up 0.1 percent, and value ETFs like IWD and VTV are only down a couple tenths. So the weakness is really concentrated in the growth-heavy names, not the whole market. Luna: Right, like Apple down 2.2 percent, NVIDIA down 2.5 percent. Those are the big drags. Lucas: Exactly. And that's the story I keep circling back to with my own portfolio. The S&P 500 is sitting near 7,672, and the top five stocks still make up a huge chunk of that index. When those names sneeze, the whole index catches a cold. But underneath, there are smaller companies that have been quietly improving their balance sheets and their earnings. Luna: So are you saying the small-cap comeback is actually happening, just not showing up in the weekly headline numbers? Lucas: That's exactly what I'm saying. Look at the Russell 2000 over a longer window. It's still underperformed the S&P 500 for years. But the last few months, the relative performance has been narrowing. And when you see a week like this, where small caps only fall 0.9 percent while big tech gets hammered, that's a signal that money is starting to rotate. Luna: And that rotation is partly driven by valuations, right? I mean, the P/E on the S&P 500 is stretched, but small caps trade at a discount to their own history. Lucas: Absolutely. The forward P/E on the Russell 2000 is still below its 25-year average, while the S&P 500 is above. That gap has historically been a pretty good predictor of future returns over the next five to seven years. So for a stock picker, that's where the opportunity set is. Luna: But aren't small caps riskier? More volatility, less liquidity, more fragile balance sheets? Lucas: They are riskier on average. But that's the point of active stock picking. You can screen for quality. I look for companies with positive free cash flow, low debt, and a moat in a niche market. And right now, there are a lot of those trading at single-digit price to earnings ratios. Luna: Give me a concrete example. What kind of company are we talking about? Lucas: Take a regional bank that got sold off last year because of the regional banking scare. If you find one with a solid loan book, a clean balance sheet, and a dividend that's well covered, it might be trading at 8 times earnings. Compare that to a big bank like JPMorgan, which is a great company but trades at a premium. Luna: And you think a stock like that could actually outperform JPM over the next decade? Lucas: I think the odds are better than most people realize. JPMorgan is priced for perfection. A small regional bank with the right fundamentals has more room to grow into its valuation. And of course, you have to diversify, because some of those banks will stumble. Luna: So how many small caps should someone actually own if they're building a concentrated portfolio? Lucas: That's the million-dollar question. If you're truly picking individual stocks, I'd say 15 to 25 names is the sweet spot. Enough to spread risk, but not so many that you can't follow each one closely. And of those, maybe a third to half could be small caps if you're comfortable with the volatility. Luna: But then you're also dealing with the challenge of index funds. More money flows into passive funds, more small caps get overlooked because they're not in the major indices. That could be an opportunity for active managers. Lucas: Exactly. And we saw that with the whole ETF phenomenon. Everyone piles into the S&P 500 ETF, and that drives up the prices of the largest companies, regardless of their fundamentals. Meanwhile, small caps are largely ignored. That's where a stock picker can actually add value. Luna: But isn't that also a risk? If the index bubble pops, small caps might get caught in the downdraft too. Lucas: There's no doubt they'd fall initially. But over the long run, what matters is earnings growth and cash flow. And that's where the small caps have the edge. They're growing earnings faster than the large caps, on average, but they're not getting the valuation multiple expansion. Luna: So it's a value play disguised as a growth play. Lucas: That's a good way to put it. And it ties into something we talked about with buybacks. Large companies have been aggressive with buybacks, which boosts earnings per share mechanically. But small companies often reinvest in their business or pay down debt instead. That can be just as good for shareholders if the company is growing. Luna: Speaking of buybacks, did you see that Meta stock is up 3.9 percent this week? That's a big bounce after that 8 percent drop we talked about a few weeks ago. Lucas: I did. And it shows how sentiment can flip quickly. But for a small-cap stock, you don't get that same kind of institutional coverage. So you have to do your own work. Which brings me to something about this show. Luna: What's that? Lucas: We talk a lot about how to think about stocks, and we try to give you frameworks you can actually use. And we're able to do that without any ads or sponsors. That's a deliberate choice on our part, because we want to be your honest guide, not someone pushing a product. Luna: Totally. That's what makes this show feel like a conversation between friends who happen to love finance. Lucas: Yeah, and if that kind of independence is valuable to you, the best way to support it is through buy me a coffee dot com slash fexingo. That's our page where you can buy us a coffee if you feel so inclined. No pressure, no perks, just knowing that you're helping us keep this ad-free. Luna: And honestly, every little bit helps. It lets us spend more time researching and less time worrying about revenue. Lucas: So back to small caps. There's also a structural reason to be interested right now. The Federal Reserve's rate policy is shifting, and that tends to benefit smaller companies more because they're more sensitive to borrowing costs. If we're at a turning point in the cycle, small caps could have a multi-year tailwind. Luna: So what's your one concrete takeaway for someone who wants to start picking small caps? Lucas: Screen for companies with a price to book ratio below the sector average, positive free cash flow for the last five years, and no major debt maturities in the next three years. That narrows the universe to maybe 200 names. Then you can start reading their earnings reports and looking for management teams that are honest about their challenges. Luna: And then you check if they're buying back stock or paying a dividend. Lucas: Right. But the key is not to overpay. Even a great small company is a bad investment if you pay 40 times earnings. Patience is part of the game. Luna: So with the Russell 2000 down slightly this week, is now a good entry point? Lucas: I think it's a good time to start building a watchlist. You don't have to buy everything today. But the valuations are attractive relative to large caps, and the market is starting to recognize that. By the time everyone's talking about the small-cap rally, the best gains will be behind you. Luna: And if you want to avoid the index concentration risk, small caps are one way to do it. Lucas: Exactly. Because right now, the S&P 500 is essentially a bet on a handful of mega-cap tech stocks. If you believe the future of the market is more broad-based, small caps are the way to express that view. But you have to be selective, and you have to be patient. Luna: That's the stock picker's creed. Lucas: It is. And if you're curious, we'll keep coming back to this theme in future episodes. For now, maybe start by looking at one small company in a sector you already understand. That's the best way to begin.