Smaller companies have a well-established reputation for delivering higher returns than their large cap peers over the longer term. This phenomenon has been labelled "the small cap effect" and has endured through economic and financial market turmoil over multiple decades. More recently, that effect has gone awry, but this could be about to change.

Over the long term, smaller companies have an impeccable track record of outperforming their larger-cap peers. Since 2000, the MSCI World Small Cap Index has delivered an annualised return of 8.7%, compared to 7.1% for the MSCI All Companies World Index (MSCI ACWI). This is in spite of the astonishing run for technology giants, such as Amazon, Apple, Microsoft and Alphabet, which form a significant share of the World Index.

The exact reasons for this strength are multifaceted. First, there is simply the law of big numbers. It is easier to grow a smaller company by 10% than it is to grow a large company by the same amount. If a small company has 1,000 customers, it needs to find 100 more, whereas the larger company, with 1,000,000 customers, needs to find another 100,000.

At the same time, smaller companies tend to be more dynamic. They may have flatter management structures and are fleeter of foot. They can react quickly to changes in the business environment, which helps them exploit emerging opportunities, unencumbered by legacy systems and processes. They may also be more domestic in nature, leaving them with shorter and more adaptable supply chains. At a time when global trade is disrupted, this could be seen as a key advantage.

A final point is that smaller companies tend to be under-researched. Many fund groups do not have the time and resources to devote to this part of the market. This can give rise to mispricing, which makes smaller companies a fertile hunting ground for active managers.

Adjusting for the situation today

Smaller companies may struggle when investors are nervous, notably during times of weak economic growth. They may also suffer when interest rates are rising. The lingering perception is that they have higher debt than their large cap peers. They are seen as more exposed to the local economy in which they operate, which can be a drag on sentiment. At Aberdeen, we believe our investment approach adjusts for these drawbacks. It helps direct us to higher quality smaller companies, with lower debt and a strong pathway of sustainable growth. It also steers us to companies that are exhibiting momentum, such as seeing upward earnings revisions. We find that businesses with these characteristics have generally been able to navigate a tougher economic climate successfully. They may even profit from them in the longer term as their competitors struggle. However, in the short-term, investors tend to treat these high-quality companies in the same way as their peers, which creates opportunities for long-term investors to buy at lower valuations. This, we believe, is the situation today

Cheap, and getting cheaper

In recent investment markets, weak sentiment has persisted towards smaller companies long beyond the point where it was supported by fundamentals. Valuations are low versus their history, versus their earnings prospects and versus their large cap equivalents. Small caps started to stage a recovery in the first half of 2024 but have been knocked off course by market volatility so far in 2025.

It is not unusual for small-cap stocks to experience prolonged periods of underperformance relative to large-cap stocks. The CFA Institute points out that small-cap stocks underperformed large-caps during the periods 1955 to 1962, 1977 to 1978, and 1989 to 2005. On average, the small-cap vs. large-cap cycle lasts about nine years, while this cycle is now 12 years and counting.

In the UK and Asia – two key areas of small cap focus for Aberdeen - small caps outperformed large caps in April’s market recovery. Once the Trump turmoil starts to ebb, selected smaller companies may be rewarded because they are less exposed to global supply chain disruption and also have a significant valuation cushion. Smaller companies would also be beneficiaries if investors started to look beyond the mega-cap technology stocks for alternative sources of growth.

We have two trusts that are focused on this part of the market – abrdn Asia Focus and abrdn UK Smaller Companies Growth Trust. There are different dynamics for each. In the UK, smaller companies have lagged a recovery in large cap companies. As investors start to rediscover UK markets, this could trickle down into smaller companies. The UK economy has tentatively returned to growth in recent months, with interest rates and inflation dropping, which should provide a favourable backdrop.

In Asia, small caps did well for much of 2024, largely as a result of the lower exposure to China in the universe (China only forms around 13% of the MSCI Asia ex Japan Small Cap Index ) and a strong performance from Indian smaller companies. They have struggled in the recent global turmoil and this has brought valuations lower, making them more attractive to long-term investors. They may also be beneficiaries of lower interest rates globally and across the region.

Looking ahead

Some of the most dynamic and exciting growth companies are to be found among smaller companies. They may have struggled with poor sentiment over recent times, but with valuations far lower, the stars could be aligning for a small cap revival. A reappraisal for the sector could be imminent. In fact, it may even have already started. 

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Issued by abrdn Fund Managers Limited, registered in England and Wales (740118) at 280 Bishopsgate, London EC2M 4AG, authorised and regulated by the Financial Conduct Authority in the UK.

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