For the past several years, investors have had little reason to look beyond mega-cap technology stocks. The "Magnificent Seven" dominated returns, leaving small-cap equities trailing well behind.

But that narrative is starting to change.

The Russell 2000 has gained nearly 21% year-to-date, outperforming the S&P 500's roughly 10% increase. And after years of outflows, investors are once again allocating capital to small-cap stocks.

Speaking on The ETF Show, Chris Parker, Senior Portfolio Manager of Thrivent Small-Cap Value ETF (TSCV), said he believes the renewed interest is being driven by three factors: improving fundamentals, attractive valuations, and the potential for broader market leadership.

"The operating environment is improving," Parker said, pointing to accelerating revenue and earnings growth among small-cap companies. Excluding the pandemic, the first-quarter of this year marked the strongest period for small-cap earnings growth since 2018.

At the same time, valuations remain compelling.

According to Parker, small-cap stocks are trading at roughly a 15% to 20% discount relative to their 30-year historical average across several valuation metrics, including price-to-earnings, free cash flow yield, and enterprise value to EBITDA. Historically, periods combining improving earnings with discounted valuations have produced favorable returns for the asset class.

That valuation gap has widened in part because investors have remained heavily concentrated in a handful of large-cap technology companies.

"The S&P 500 has become quite top-heavy," Parker said, noting that the ten largest companies now represent roughly 40% of the index while information technology alone accounts for about 40% of its weighting.

Rather than chasing those market leaders, Parker believes investors should focus on high-quality, value companies that see benefits from improving economic conditions.

"We look to buy sound or improving businesses led by capable and well-aligned management teams when they're trading at substantial discounts to our estimate of intrinsic value," he said.

Parker explained that Thrivent is finding opportunities across industrials and consumer companies, particularly businesses improving margins, strengthening competitive positions, or using artificial intelligence to improve operational efficiency, even if they aren't direct AI plays themselves.

But though investors may find many small-caps “cheap,” Parker said that small-cap investing still requires careful security selection.

Roughly one-quarter to one-third of small-cap companies are not profitable, and many have yet to consistently earn returns above their cost of capital. That wide dispersion in quality, he argues, makes active management particularly valuable.

"We think one of the biggest mistakes investors make is viewing small caps as a homogeneous group," Parker said.

He also warned against treating small-cap allocations as purely tactical trades based on interest-rate expectations or macroeconomic headlines.

Instead, Parker advocates a patient approach, typically holding companies for two to four years while waiting for improving fundamentals to be reflected in share prices.

"We know that if we're growing earnings power over time, even if share prices don't move immediately, the undervaluation is building," he said. "We think of that as a coiled spring to generating returns."

As market leadership continues to broaden beyond mega-cap technology, Parker believes small caps may finally be positioned to emerge from the shadows.

Source: The ETF Show - Small Caps are Having a Moment: Why Investors are Paying Attention